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BANKING    AND    CREDIT 

A  TEXTBOOK  FOR  COLLEGES  AND  SCHOOLS 
OF  BUSINESS  ADMINISTRATION 


By 

DAVIS  RICH  DEWEY 

Professor  of  Economics  and  Statistics,  Massachusetts 
Institute  of  Technology 

and 

MARTIN  JOSEPH  SHUGRUE 

Assistant  Professor  of  Economics,  Massachusetts 
Institute  of  Technology 


NEW   YORK 
THE  RONALD  PRESS  COMPANY 

1922 


Copyright,  1922,  by 
The  Ronald  Press  Company 


All  Rights  Reserved 


H^ 


^ 


PREFACE 

'         The  field  of  banking  and  credit  is  so  extensive  that  it  is  im- 

-  possible  to  describe  all  its  features  in  a  volume  of  moderate 

,vi  compass.    This  text  is  therefore  restricted  in  its  content.    It  is 

written  primarily  to  meet  the  needs  of  the  individual  who  uses 

the  bank  for  credit  accommodation;  its  aim  is  to  explain  the 

^'  problems  confronting  the  customers  of  a  bank,  and  the  significant 

•  factors  that  control  the  terms  and  concUtions  upon  which  credit 

I  may  be  obtained. 

^       The  different  forms  of  credit  instruments  are  described  and 

emphasis  is  placed  upon  procedure  by  which  loans  are  obtained 

'  and  the  methods  of  determining  credit  risks.    To  make  room  for 

X  this,  less  attention  is  given  to  the  history  of  banking,  to  invest- 

A  ment  forms  of  banking,  and  to  theoretical  questions  concerned 

with  the  nature  and  principles  of  money  and  credit.    It  is  as- 

'Sumed  that  the  reader  has  some  familiarity  with  the  chapters 

J  on  money  and  banking  which  are  found  in  all  elementary  texts 

j\    on  economics,  and  the  purpose  of  this  volume  is  to  supplement 

I     these  chapters  by  more  detailed  description  and  illustration  of 

actual  practice  in  the  business  world. 

A  few  specific  references  are  given  at  the  end  of  each  chapter 
to  aid  those  who  wish  to  read  further  on  particular  topics;  and  in 
the  Appendix  will  be  found  carefully  chosen  problems  and  exer- 
cises with  solutions,  designed  to  make  clear  the  customary 
process  of  banking  and  credit  operations. 

Davis  R.  Dewey 
Martin  J.  Shugrue 
Cambridge,  Mass. 
May  lo,  1922 


CONTENTS 


Chapter  Page 

I  Money  and  Credit i 

II  Stock  of  Money 8 

III  Commercial  Credit  Instruments     ......  34 

rv  Commercial  Credit  Documents 58 

V  Letters  of  Credit 71 

VI  Negotiability 80 

VII  Business  of  Banking 94 

VIII  Various  Kinds  of  Banking  and  Credit  Institutions  102 

IX  The  Balance  Sheet  of  a  Bank 126 

X  Funds  Belonging  to  Stockholders 142 

XI  Deposits 150 

XII  National  Bank  Note  Circulation        .....  164 

XIII  Commercial  Loans 175 

XIV  Security  for  Loans 188 

XV  The  Credit  Statement 208 

XVI  Analysis  Ratios 220 

XVII  Individual  Items  of  a  Credit  Statement      .      .      .  231 

XVIII  Analysis  of  Typical  Credit  Statements  .      .     .      .  255 

XIX  Security  and   Other  Investments   of   Commercial 

Banks 263 

XX  Cash  Holdings  and  Reserve  of  a  Commercial  Bank  270 

XXI  The  Clearing  House 289 

XXII  Defects  of  the  National  Banking  System   .     .     .  301 

XXIII  Organization  of  Federal  Reserve  System    .     .      .  309 

XXIV  Rediscounting  by  Federal  Reserve  Banks  .      .     .  2>ii 

V 


VI  CONTENTS 

Chapter  Page 

XXV    Other  Operations  of  Federal  Reserve  Banks  344 

XXVI    Acceptances 357 

XXVII    Principles  of  Foreign  Exchange 370 

XXVIII    The  Process  of  Foreign  Exchange 385 

XXIX    Typical  Foreign  Exchange  Transactions      •     .     ■  395 

XXX    The  New  York  Money  Market 409 

XXXI    Monetary  Problems 427 

Appendix  A — Problems  with  Solutions 453 

B — Problems  without  Solutions 477 

C — Interest  Tables 483 

D — Value  of  Foreign  Coins 493 

E— Bibliography 496 


Forms 


Form  Page 

1.  Bill  of  Exchange  Drawn  at  60  Days 35 

2.  Trade  Acceptance 39 

3.  Bank  Acceptance 39 

4.  Bank  Check 41 

5.  Promissory  Note 47 

6.  Travelers'  Check 52 

7.  Certificate  of  Deposit 54 

8.  Railroad  Bill  of  Lading 61 

9.  Shipper's  Invoice 62 

10.  Shipper's  Draft 63 

1 1 .  Warehouse  Receipt 64 

12.  Trust  Receipt 68 

13.  Import  Letter  of  Credit  (Dollars) 72 

14.  Travelers'  Sterling  Letter  of  Credit 76,  77 

15.  Collateral  Loan  Agreement 189 

16.  Borrower's  Statement 213,214 

17.  Map  of  Federal  Reserve  Districts 310 

18.  Chartof  Reserve  Percentages  of  Federal  Reserve  Banks 351 

19.  Diagram  Illustrating  the  Financing  of  a  Shipment  of  Goods  by 

Means  of  Bankers'  Acceptances .■ 360 


vu 


Banking  and  Credit 


CHAPTER  I 
MONEY  AND  CREDIT 

1.  Close  Relationship  of  Money  and  Credit. — In  the  highly 
complicated  mechanism  of  economic  processes  which  society  has 
created  for  the  carrying  on  of  business,  no  parts  have  aroused 
more  interest  and  inquiry  than  money  and  credit.  They  are 
closely  allied  with  each  other  in  their  uses  and  are  generally 
treated  together  under  the  heading  of  "exchange"  by  authors  of 
systematic  textbooks  on  the  principles  of  economics.  Notwith- 
standing this  intimate  relationship,  they  are  fundamentally 
different  in  their  origins  and  in  many  of  their  characteristics.  It 
is  therefore  necessary  to  note  briefly  the  essential  nature  of  each 
before  entering  upon  the  explanation  of  the  monetary  system  of 
the  United  States  and  the  credit  agencies  and  instruments  which 
are  in  current  use. 

2.  Meaning  of  "  Money.  " — Money,  by  time-honored  de- 
scription, is  a  medium  of  exchange,  a  measure  of  value,  a  standard 
of  deferred  payments,  and  a  store  of  value.  These  functions  are 
so  diverse  that  it  is  difficult  to  give  a  definition  of  money  which 
will  cover  all  its  characteristics.  Some  authorities  place  the 
emphasis  on  the  service  which  money  renders  as  a  standard  of 
value;  others  on  its  use  as  a  medium  of  exchange.  As  a  result 
some  limit  the  use  of  the  term  "money"  to  the  instruments  of 
exchange  which  have  intrinsic  or  commodity  value,  thus  exclud- 


2  BANKING  AND  CREDIT  [I 

ing  all  forms  of  paper  money;  others  include  under  the  term  all 
instruments  which  effect  exchange. 

The  exchange  of  values  is  effected  by  a  variety  of  instruments. 
Included  in  the  list  are  gold  buUion,  coins  minted  by  the  govern- 
ment, promissory  notes  issued  by  the  government,  bank  notes, 
checks  of  individuals  and  corporations,  drafts,  bills  of  exchange, 
acceptances,  travelers'  checks,  certificates  of  deposit,  postal 
money-orders,  bills  receivable,  and  promissory  notes  of  individ- 
uals and  corporations.  For  the  ordinary  transactions  of  retail 
trade  and  wage  payments,  small  coins  and  paper  money  issued 
by  the  government  or  by  banks  are  in  familiar  use,  and  to  an 
increasing  extent  individual  checks  are  employed  in  these  settle- 
ments of  indebtedness.  In  transactions  involving  larger  sums 
checks  are  commonly  used;  and  for  payments  at  a  distance,  bills 
of  exchange  and  drafts  occupy  a  prominent  place. 

Not  all  of  these  instruments,  however,  are  serviceable  as  a 
standard  of  value,  although  they  are  highly  convenient  as  a 
medium  of  exchange.  Gold,  because  of  the  worldwide  estimation 
in  which  it  is  held,  most  completely  satisfies  the  requirements  of  a 
standard  of  value,  and  to  a  certain  degree  it  is  a  medium  of  ex- 
change. Other  instruments,  however,  may  perform  much  of  the 
exchange  work  of  the  community  better  than  gold.  A  check  is  an 
excellent  medium  of  exchange,  but  is  worthless  as  a  standard  of 
deferred  payments. 

3.  Various  Definitions  of  Money. — The  conflict  of  opinion  in 
regard  to  the  definition  of  money  is  well  summed  up  by  Conant 
in  the  opening  pages  of  his  treatise  on  "  The  Principles  of  Money 
and  Banking."  After  limiting  the  definition  of  money  to  that 
"commodity  of  intrinsic  value  acceptable  in  exchanges  which 
has  become  by  law  or  custom  the  usual  tender  for  debt,"  he 
continues : 

Put  into  more  popular  language,  this  means  that  the  term 
money, -under  existing  social  conditions,  is  applicable  to  gold  or 


1!  MONEY  AND  CREDIT  3 

silver  coin,  and  should  not  be  extended  to  the  various  forms  of 
paper  which  economize  the  use  of  money.  For  most  practical 
purposes,  gold  bullion  held  in  bank  reserves  is  properly  classed  as 
money,  and  falls  within  the  definition  given.  .  .  .  The  use  of 
the  word  money  is  extended  by  many  authorities  to  different 
forms  of  credit  obligations — by  some  to  redeemable  government 
paper  or  redeemable  bank-notes;  by  others  to  irredeemable  paper 
of  either  type;  and  by  still  others  to  the  checks,  deposit  entries, 
and  various  written  instruments  which  are  employed  in  carrying 
on  exchanges.  The  difficulty  about  these  extensions  of  the  defini- 
tion beyond  coined  metal  of  intrinsic  value  is  that  there  is  no 
logical  point  at  which  the  things  included  in  the  definition  of 
money  terminate.  If  the  definition  is  extended  to  instruments  of 
paper  credit,  it  is  not  clear  why  it  should  stop  with  legal  tender 
instruments  and  fail  to  include  bank-notes  which  are  not  legal 
tender.  If  it  is  extended  to  the  latter,  it  is  not  clear  why  it  should 
not  extend  also  to  foreign  bills  of  exchange,  which  are  kept  by 
many  of  the  European  banks  as  a  part  of  their  coin  reserves, 
ready  to  be  sold  for  coin  whenever  they  have  need  for  it.  ■ 

Although  there  is  a  wide  difference  between  a  gold  coin  and  a 
check  representing  an  order  upon  a  bank  to  pay  a  certain  sum,  it 
is  not  necessary  in  a  preliminary  description  of  the  various  in- 
struments of  exchange  which  serve  the  needs  of  business  society, 
to  make  a  definitive  and  final  choice  of  the  media  which  are  to  be 
included  under  the  term  *' money."  Such  a  definition  is  impor- 
tant in  the  analysis  of  certain  applications  of  monetary  theory, 
as  the  quantity  theory  of  money  and  the  relation  of  money  to 
prices,  but  further  discussion  on  this  point  is  deferred  to  a  subse- 
quent chapter. 

4.  The  Nature  of  Credit. — The  nature  of  credit  can  best  be 
approached  by  considering  some  of  the  operations  involved  in  the 
production  of  wealth.     Among  the  agents  which  co-operate  in 


'  Vol.  I,  pp.  4-5.  Forfurther  definitions  of  money,  see  W.  A.  Scott,  Money  and  Bank- 
ing, p.  I ;  F.  M.  Taylor,  Some  Chapters  on  Money,  pp.  11-12;  F.  A.  Walker,  Money,  Trade 
and  Industry,  p.  4;  D.  Kinley.  Money,  pp.  70-71;  E.  W.  Kemmerer,  Money  and  Prices,  pp. 
27-28;  J.  F.  Johnson,  Money  ana  Currency,  pp.  6-7. 


4  BANKING  AND  CREDIT  '  [I 

production  is  capital.  It  may  exist  in  the  form  of  tools,  machin- 
ery, workshops,  factories,  railway  equipment,  shipping,  as  well 
as  of  cash  or  money.  For  nearly  all  forms  of  industry  the  work  of 
producing  an  individual  commodity  stretches  over  a  considerable 
period  of  time.  When  the  article  is  finished  there  is  often  a 
further  addition  of  time  before  the  commodity  is  purchased,  and 
even  then  there  may  be  a  delay  in  the  payment.  The  producer, 
therefore,  must  have  the  use  of  wealth  not  only  to  provide  the 
initial  equipment,  to  purchase  raw  material,  to  hire  laborers  who 
must  be  paid  long  before  there  are  any  returns,  and  to  pay  insur- 
ance and  taxes  which  are  imposed  though  the  goods  are  not  yet 
sold,  but  also  to  bridge  over  the  delays  before  payment  is  received 
for  the  goods  sold.  The  producer  needs  present  purchasing 
power;  he  may  have  saved  the  capital  which  he  uses,  or  he  may 
borrow  it.  If  he  borrows  it  he  employs  the  service  of  credit  and 
the  essential  characteristic  of  this  is  the  possession  of  present  pur- 
chasing power  in  return  for  a  promise  to  pay  in  the  future.  If  the 
producer  borrows  in  order  to  establish  the  initial  enterprise  he 
will  probably  borrow  for  a  long  period  of  time,  obtaining  capital 
from  those  who  do  not  wish  to  employ  it  under  their  own  super- 
vision. The  evidence  of  such  borrowing  will  appear  as  long-time 
notes,  bonds,  and  similar  instruments.  But  even  if  borrowing  is 
not  necessary  for  the  establishment  of  the  initial  Undertaking,  it 
is  likely  to  occur  before  a  final  settlement  is  made  in  the  sale  of 
goods. 

Economic  organization  is  highly  complex  and  there  are  many 
interruptions  in  the  marketing  of  goods.  Moreover,  if  there  be 
an  increasing  demand  for  the  goods  in  the  production  of  which 
this  producer  is  engaged,  the  use  of  more  capital  is  required. 
Every  effort  is  therefore  made  to  obtain  control  of  capital  by  the 
use  of  credit.  Finished  goods,  even  before  they  are  sold,  may  be 
pledged  to  secure  capital ;  and  if  the  goods  are  sold  but  not  paid 
for,  the  accounts  may  be  pledged.  If  the  producer  has  a  previous 
record   of   success  which  inspires   confidence,   capital   may   be 


I]  MONEY  AND  CREDIT  5 

borrowed  without  the  pledge  of  any  specific  property.  To  pro- 
vide these  credits,  a  speciaHzed  economic  mechanism  has  been 
devised,  consisting  of  banking  institutions  and  credit  instruments. 
Thus  by  means  of  credit,  capital  as  one  of  the  agents  of  production 
is  placed  where  it  can  be  made  more  effective,  and  undoubtedly 
the  development  of  these  facihties  is  one  of  the  most  powerful 
influences  in  the  creation  of  wealth  on  the  scale  which  the  world 
now  enjoys. 

5.  Credit  as  an  Exchange  Factor. — Inasmuch  as  credit  pre- 
sumes the  payment  of  money — and  payment  within  a  short  time 
if  the  credit  be  of  early  maturity — credit  instruments  are  often  as 
convenient  for  the  purposes  of  exchange  as  the  money  commodity 
itself.  Communities  in  their  economic  development  have  con- 
stantly struggled  to  improve  their  methods  of  exchanging  wealth; 
from  primitive  barter  they  passed  to  the  use  of  monetary  media 
which  became  standards  of  value.  But  with  the  growth  of  com- 
merce and  trade  they  have  utilized  a  great  variety  of  credit  in- 
struments which  have  become  serviceable  for  exchange  purposes. 
The  credit  tools  devised  to  make  capital  more  productive  have 
also  been  found  available  for  carrying  on  the  work  of  exchange. 

Some  forms  of  credit,  as  the  promissory  notes  of  the  govern- 
ment and  of  banks,  may  prove  so  acceptable  that  they  readily 
circulate  and  become  a  part  of  the  money  stock.  Their  credit 
significance,  however,  must  always  be  kept  in  mind,  for  they  do 
not,  simply  through  their  creation,  add  to  the  wealth  of  the 
nation.  The  addition  of  $100,000,000  in  gold  increases  the 
national  wealth;  the  addition  of  an  equal  sum  of  promissory  notes 
does  not  at  the  moment  increase  the  total  wealth.  It  may  set  in 
motion  forces  which  will  ultimately  create  wealth,  for,  as  Mill 
states  it,  ''although  the  production  funds  of  the  country  are  not 
increased  by  credit,  they  are  called  into  a  more  complete  state  of 
productive  activity."^ 

2  J.  S.  Mill.  Principles  of  Political  Economy,  Book  III,  Ch.  XI. 


6  BANKING  AND  CREDIT  [I 

The  great  increase  in  the  production  of  wealth  witnessed 
during  the  past  century  is  due  not  only  to  the  discovery  of  new 
mechanical  processes  and  applications  of  natural  and  physical 
science,  but  in  large  measure  also  to  the  extension  of  credit  facili- 
ties. So  remarkable  has  been  this  extension  of  credit  and  so  ser- 
viceable has  been  its  uses  in  effecting  the  transfer  of  values,  that 
some  have  been  led  into  the  error  that  commodity  money  could 
be  abandoned  and  that  all  exchange  operations  might  be  satis- 
factorily performed  through  credit  substitutes. 

Authors  of  textbooks  on  economics  usually  treat  the  subject 
under  four  main  headings:  production  of  wealth,  exchange  of 
wealth,  distribution  of  wealth,  and  consumption  of  wealth.  As 
credit  has  become  so  large  a  factor  in  the  operations  of  exchange, 
it  is  generally  discussed  under  the  second  of  the  above  headings. 
Exchange,  therefore,  includes  not  only  the  characteristics  and 
functions  of  money,  but  also  the  use,  development,  and  influence 
of  credit  instruments,  the  character  of  banking  institutions  which 
enlarge  the  use  of  credit,  and  the  relation  of  the  quantity  of 
money,  including  credit  substitutes,  to  prices  and  the  money 
market.  It  must,  however,  be  ever  kept  in  mind  that  credit 
primarily  has  to  do  with  the  transfer  of  wealth  in  the  form  of 
capital  as  a  productive  agent.  Because  of  its  serviceability  as  a 
tool  of  exchange,  however,  it  is  allied  to  money,  and  the  discussion 
of  the  one  involves  the  discussion  of  the  other. 

6.  Credit  in  Relation  to  Prices. — One  further  point  should  be 
raised  before  entering  upon  the  following  descriptive  chapters. 
The  use  of  credit  makes  available  a  mass  of  values  as  a  medium 
of  exchange.  Does  the  addition  of  these  credit  media  affect  the 
value  of  the  commodity  money  medium,  and  thus  affect  prices? 
Do  credit  tools,  which  undoubtedly  aid  money,  under  its  narrow- 
est definition,  in  the  work  of  exchange,  modify  the  value  of 
money?  If  so,  the  development  of  credit  assumes  a  new  impor- 
tance and  its  use  becomes  a  price-making  factor.    This  is  a  ques- 


I]  MONEY  AND  CREDIT  7 

tion  which  has  aroused  much  dispute,  but  its  discussion  is  for  the 
present  deferred.  It  is  raised  at  this  point  in  order  that  the  reader 
may  recognize  that  credit  may  be  more  than  an  agency  in  render- 
ing capital  productive,  or  simply  a  part  of  the  machinery  whereby 
values  are  exchanged. 

References 

Practically  all  treatises  and  textbooks  on  general  economics 
devote  paragraphs  to  the  nature  and  functions  of  money  and 
credit.  Specific  references  are  not  needed,  as  these  texts  are 
indexed. 

Money 

Conant,  C.  A.     Principles  oi  jNIoney  and  Banking.     Vol.  I,  pp.  17-31. 
Holdsworth,  J.  T.     ]\Ioney  and  Banking,     pp.  12-16. 
Jevons,  W.  H.     Money  and  the  Mechanism  of  Exchange. 

On  the  functions  of  money,  pp.  14-18. 
Johnson,  J.  F.     Money  and  Currency,     pp.  11-17. 
Kinley,  D.     Money,     pp.  59-70. 
Laughlin,  J.  L.     Principles  of  Money. 

On  the  functions  of  money,  pp.  1-22. 
Scott,  W.  A.     Money  and  Banking,     pp.  2-13. 
Taylor,  F.  M.     Some  Chapters  on  Money,     pp.  11-33. 
Walker,  F.  A.     Money. 

On  the  primitive  functions  of  money  and  contains  generous  quota- 
tions from  other  writers,  pp.  i-i 23. 

Credit 

Johnson,  J.  F.     Money  and  Currency,     pp.  34-41. 

Laughlin,  J.  L.     Principles  of  Money,     pp.  71-114. 

Moulton,  H.  G.     Financial  Organization  of  Society,     pp.  1 21-13 1. 

Principles  of  Money  and  Banking,     pp.  5-12. 

Phillips,  C.  A.     Readings  in  Money  and  Banking,     pp.  1-9. 
Westerfield,  R.  B.     Banking  Principles  and  Practice.      Vol.  I,  pp.  35-47. 


CHAPTER  II 

STOCK  OF  MONEY 

I.  Legal  Tender  and  Lawful  Money. — Preliminary  to  the 
description  of  the  different  kinds  of  money,  one  special  attribute 
of  money — its  use  as  legal  tender  or  as  lawful  money — requires 
explanation.  As  will  be  presently  noted,  the  United  States  has 
a  composite  body  of  monetary  instruments.  When  our  coinage 
system  was  established  in  1792,  silver  as  a  monetary  standard 
held  an  important  position  throughout  the  world.  Congress 
authorized  the  use  of  both  gold  and  silver  as  standard  money. 
There  were  at  the  time  few  banks  and  their  note  issues  were  not 
large  in  comparison  with  metallic  money.  Within  a  few  years 
banks  began  to  multiply  and  their  issues  were  large.  These  notes 
however  had  no  special  legal  attributes;  they  were  simply  the 
promissory  notes  of  the  institutions  creating  them  and  their 
acceptance  depended  only  on  public  confidence. 

Again,  as  the  result  of  urgent  financial  need  of  the  government, 
Congress  at  various  times  authorized  the  issue  of  promissory 
notes  by  the  government,  and  during  the  Civil  War,  in  order  to 
strengthen  this  financial  prop,  made  the  notes  legal  tender. 
State  bank  notes  were  driven  out  of  circulation  by  taxation  and 
national  bank  notes  took  their  place.  The  inconvenience  of 
using  gold  and  silver  as  media  led  to  the  use  of  substitutes  in  the 
form  of  certificate  money.  And  more  recently,  in  the  attempt  to 
reform  our  banking  system,  the  Federal  Reserve  Act  provided 
for  a  new  form  of  note  designed  ultimately  to  eliminate  the 
national  bank  note. 

Thus  from  time  to  time  new  forms  of  money  have  been  added. 
But  as  the  government  is  slow  in  every  department  of  political 
activity  to  discard  old  forms,  so  in  the  money  system  it  has  re- 


II]  STOCK  OF  MONEY  9 

tained  varieties  of  money  which  have  no  immediate  significance 
and  which  would  probably  find  no  place  if  a  new  monetary  system 
should  be  established  in  accordance  with  present  economic  needs. 
Silver,  for  example,  has  been  discarded  as  a  standard  by  nearly  all 
nations;  but  although  the  United  States  no  longer  provides  for 
free  coinage  of  silver  dollars,  it  retains  a  certain  portion  inherited 
from  the  period  when  silver  was  recognized  as  a  standard  money. 
So,  too,  the  federal  government  issued  a  large  amount  of  promis- 
sory notes  during  the  Civil  War.  It  redeemed  a  portion  of  these 
obligations  but  left  the  liquidation  incomplete.  There  is  there- 
fore still  in  circulation  a  considerable  volume  of  United  States 
notes,  although  the  government  is  abundantly  able  to  meet  this 
indebtedness.  The  plan  to  abolish  the  national  bank  note  circu- 
lation by  the  substitution  of  federal  reserve  notes  has  been  in- 
terrupted by  the  recent  war.  As  a  result  of  this  past  experience 
we  possess  a  heterogeneous  mass  of  monetary  instruments. 

Not  all  of  them  are  legal  tender  or  lawful  money;  that  is, 
creditors  cannot  be  forced  by  law  to  accept  them  in  payment  of 
indebtedness.  The  statutes  define  which  kinds  of  money  are 
legal  tender  and,  in  the  absence  of  special  contracts,  these  forms 
must  be  accepted,  if  tendered,  whenever  the  amount  of  the  pay- 
ment is  expressed  in  dollars. 

2.  Various  Forms  of  American  Paper  Money. — This  point 
may  be  illustrated  by  reference  to  the  statements  made  on  the 
various  forms  of  paper  money  in  circulation  at  the  present  time: 

United  States  note,  popularly  known  as  "greenback": 

This  note  is  a  legal  tender  at  its  face  value  for  all  debts  public 
and  private,  except  duties  on  imports  and  interest  on  the  public 
debt. 

Gold  certificate: 

This  certifies  that  there  have  been  deposited  in  the  Treasury 
of  the  United  States  of  America dollars  in  gold  coin  pay- 


10  BANKING  AND  CREDIT  [  II 

able  to  the  bearer  on  demand.  [More  specifically  the  federal 
statutes  declare  that]  Such  certificates  shall  be  receivable  for 
customs,  taxes,  and  all  public  dues,  and  when  so  received  may  be 
reissued,  and  when  held  by  any  banking  association  may  be 
counted  as  a  part  of  its  lawful  reserve.  (Act  of  March  14,  1900. 
sec.  6.) 

By  later  legislation  (December  24,  1919)  these  notes  have 
been  given  full  legal  tender  power. 

Silver  certificate: 

This  certifies  that  there  have  been  deposited  in  the  Treasury 

of  the  United  States silver  dollars  payable  to  the  bearer 

on  demand.  This  certificate  is  receivable  for  customs,  taxes,  and 
all  public  dues,  and  when  so  received  may  be  reissued. 

National  bank  note : 

This  note  is  receivable  at  par  in  all  parts  of  the  United  States 
in  payment  of  all  taxes  and  excises  and  all  other  dues  to  the 
United  States  except  duties  on  imports  and  also  for  all  salaries 
and  other  debts  and  demands  owing  by  the  United  States  to 
individuals,  corporations  and  associations  within  the  United 
States  except  interest  on  the  public  debt. 

Federal  reserve  note: 

This  note  is  receivable  by  all  national  and  member  banks  and 
federal  reserve  banks  and  for  all  taxes,  customs  and  other  public 
dues.  It  is  redeemable  in  gold  on  demand  at  the  Treasury  De- 
partment of  the  United  States  in  the  City  of  Washington,  District 
of  Columbia,  or  in  gold  or  lawful  money  at  any  federal  reserve 
bank 

Federal  reserve  bank  note : 

This  note  is  receivable  at  par  in  all  parts  of  the  United  States 
in  payment  of  all  taxes  and  excises  and  all  other  dues  to  the 
United  States  except  duties  on  imports  and  also  for  all  salaries 
and  other  debts  and  demands  owing  by  the  United  States  to  in- 
dividuals, corporations  and  associations  within  the  United  States 
except  interest  on  public  debt. 


II]  STOCK  OF  MONEY  II 

Some  kinds  of  money  are  full  legal  tender  in  the  satisfaction 
of  all  kinds  of  debt,  both  public  and  private;  some  are  receivable 
for  one  purpose  and  not  for  another.  Others  have  no  legal  tender 
attribute  but  because  of  their  general  acceptability  perform  most 
of  the  functions  characteristic  of  money  instruments.  Gold  coins 
and  gold  certificates  of  whatever  denomination  are  legal  tender; 
so  are  silver  dollars.  Subsidiary  silver  coins  and  minor  coins  are 
legal  tender  for  limited  amounts.  United  States  notes  are  legal 
tender,  though  they  may  be  excluded  from  certain  governmental 
payments;  and  silver  certificates  are  acceptable  for  some  public 
debts  but  not  for  private  debts.  National  bank  notes  and  federal 
reserve  bank  notes  are  not  legal  tender  but  are  receivable  for  all 
public  dues  except  duties  on  imports,  while  federal  reserve  notes, 
though  not  legal  tender,  are  receivable  for  all  public  dues  without 
any  restriction.  In  common  business  practice  little  regard  is  paid 
to  these  differences,  but  banking  institutions  which  must  hold 
reserves  in  legal  tender  money  against  outstanding  obligations, 
whether  of  deposits  or  note  issues,  must  note  these  distinctions, 
and  to  them  the  quality  of  the  money  held  in  their  vaults  is 
important. 

The  terms  "legal  tender"  money  and  "lawful"  money  are 
not  always  synonymous.  l"he  term  "legal  tender"  is  explicit: 
It  includes  all  forms  of  money,  whether  coins  or  paper  credit 
notes,  which  the  law  compels  creditors  to  accept.  The  signifi- 
cance of  "lawful "  money  is  not  so  exact.  Although  contracts  and 
mortgages  are  frequently  made  pledging  the  payment  of  a  certain 
sum  of  "lawful  money  of  the  United  States"  the  courts  have 
construed  this  phrase  in  some  cases  as  meaning  "legal  tender"; 
in  others,  as  any  currency  which  is  lawfully  employed  in  buying 
and  selling.  Under  this  interpretation  bank  notes  would  be  law- 
ful money  though  not  legal  tender. 

The  significance  of  the  legal  tender  quality  is  frequently  over- 
emphasized. Confusion  of  thought  in  regard  to  the  attributes 
of  money  has  led  to  a  claim  that  because  government  promissory 


12  BANKING  AND  CREDIT  [II 

notes  are  a  good  medium  of  exchange,  they  can  be  made  to  serve 
as  a  standard  of  deferred  payments,  simply  by  conferring  upon  the 
notes  the  legal  tender  quality.  Legal  tender  legislation  is  an 
incident  to  a  clearer  definition  of  contracts.  Value  is  determined 
by  public  estimation,  a  force  far  deeper  than  statute.  If  the 
government  changes  one  term  of  the  value  ratio,  buyers  and  sellers 
will  through  price  adjustments  change  the  other  accordingly. 

3.  Monetary  Stock  and  Money  in  Circulation. — A  distinction 
is  to  be  made  between  monetary  stock,  or  the  general  stock  of 
money,  and  money  in  circulation.  According  to  ofhcial  practice 
the  Treasury  Department  includes  under  "monetary  stock" 
gold  coin,  including  bullion  in  the  Treasury,  standard  silver 
dollars,  subsidiary  silver.  United  States  notes,  treasury  notes 
of  1890,  federal  reserve  notes,  federal  reserve  bank  notes,  and 
national  bank  notes. 

In  1920  (July  i),  this  monetary  stock  amounted  to  $7,894.4 
million  classified  as  follows: 

Millions 

Gold  coin  (including  bullion  in  the  Treasury') $2,694.0 

Silver  dollars 267.0 

Subsidiary  silver 258.9 

United  States  notes 346.7 

Treasury  notes  of  1 890 1.7 

Federal  reserve  notes 3i405-9 

Federal  reserve  bank  notes 201.2 

National  bank  notes 7i9-o 

Total 17,894.4 


In  addition  there  were  about  $87  million  of  minor  coins  not 
included  in  the  monthly  statement  of  monetary  circulation.  This 
table  does  not  include  gold  and  silver  certificates,  for  these  are 
simply  claims  on  other  forms  of  money  listed  in  the  table.  On 
the  other  hand,  this  table  overstates  the  amount  of  money  which 
is  actually  in  circulation.  Not  all  of  the  above  stock  is  in  circula- 
tion at  the  same  time.    Some  of  the  gold  is  held  by  the  Treasury 


II] 


STOCK  OF  MONEY 


13 


as  a  reserve  against  government  promissory  notes  or  greenbacks, 
and  some  is  held  by  federal  reserve  banks  as  reserve  against 
federal  reserve  notes.  Moreover,  the  item,  federal  reserve  notes, 
includes  several  hundred  million  dollars  of  notes  not  as  yet  issued 
for  circulation.  Of  the  general  stock,  $7,894  million,  a  part  was 
held  in  the  Treasury  as  assets  of  the  government  and  a  part  by 
federal  reserve  banks  and  federal  reserve  agents  against  issues  of 
federal  reserve  notes.  This  left  for  "money  in  circulation,"' 
only  about  three-fourths  of  the  "  general  stock, "  or  $6,088  million. 
This  gives  a  per  capita  circulation  of  $57.21.  Considerably  less 
than  half  of  the  total  stock  is  metallic  money,  and  a  part  of  this 
latter  circulates  in  a  representative  form  as  certificates. 

The  following  table  shows  the  growth  of  the  total  monetary 
stock  and  money  in  circulation  since  1900: 

Total  Monetary  Stock  and  Money  in  Circulation 

Qn  millions) 


Year 

Total  Stock 

Money  in 
Circulation 

Year 

Total  Stock 

Money  in 
Circulation 

1 901 

$2,438 

$2,175 

191 1 

$3,556 

$3,214 

1902 

2,563 

2,249 

1912 

3,649 

3,285 

1903 

2,685 

2,368 

1913 

3,620 

3,364 

1904 

2,804 

.      2,519 

1914 

3,738 

3,402 

1905 

2,883 

2,588 

1915 

3,989 

3,569 

1906 

3-071 

2,737 

1916 

4,483 

4-024 

1907 

3,116 

2,773 

1917 

5,408 

4,764 

1908 

3-379 

3,038 

1918 

6,741 

5,379 

1909 

3.406 

3,106 

1919 

7,519 

5,766 

1910 

3-420 

3,102 

1920 

7,895 

6,088 

There  have  been  wide  fluctuations  in  the  volume  of  money  in 
circulation  at  different  periods;  and  over  Jong  periods  there  has 

'  The  Federal  Reserve  Bulletin  in  its  current  issues  gives  a  different  figure  for  the  amount 
held  by  federal  reserve  banks  and  agents,  as,  for  example,  for  the  date  under  consideration. 
July  1,  1920,  $2,021  million.  The  subtraction  of  this  sum,  together  with  the  8485  million 
held  by  the  government,  leaves  $5,381  million  in  circulation.  This  results  in  a  per  capita 
circul£>tion  of  Sso.19,  as  compared  with  $57.21  in  the  Treasury  statement. 


14 


BANKING  AND  CREDIT 


II 


been  an  increase  not  only  in  the  total  amount  but  also  in  propor- 
tion to  the  population.    This  is  seen  in  the  following  table: 

Increase  in  Per  Capita  Circulation  since  1880 


Amount 

Percentage  Gain 

Percentage  Gain 

July  I 

(Millions) 

in  Ten  Years 

Per  Capita 

in  Ten  Years 

1880 

#9734 

$19.41 

1890 

1,429-3 

47 

22.82 

16 

1900 

2,055.2 

44 

26.93 

17 

1910 

3,102.4 

57 

34-33 

29 

1920 

6,087.6 

96 

57-21 

65 

Most  marked  was  the  increase  after  191 5.  In  that  year  the 
per  capita  circulation  was  $35.44.  In  the  next  five  years  the  per 
capita  gain  was  between  $4  and  $5  annually. 

4.  Gold  Coinage. — Although  gold  constitutes  an  important 
part  of  the  total  monetary  stock,  ranging  from  two-fifths  to  more 
than  half  during  the  past  ten  years,  it  is  rarely  seen  in  circulation. 
A  part  is  held  by  the  Treasury  in  trust  to  secure  the  more  con- 
venient gold  certificates  and  as  a  reserve  to  protect  the  legal 
tender  notes,  and  a  much  larger  portion  is  in  the  vaults  of  the 
federal  reserve  banks,  kept  as  reserve  against  their  deposit  and 
note  obligations,  and  as  a  gold  settlement  fund  for  clearing  house 
purposes.  As  reserves,  gold  accomplishes  a  greater  amount  of 
exchange  service  than  if  employed  as  an  active  circulating  me- 
dium. Only  a  small  portion  of  the  total  gold  stock  is  to  be  found 
outside  of  the  Treasury  and  the  federal  reserve  banks. 

The  monetary  standard  is  gold  and  the  gold  dollar  (its  equiva- 
lent, but  not  coined)  is  the  standard  unit  of  value.  Gold  bullion 
may  be  coined  without  any  limitations  when  presented  at  the 
mint.  Gold  coin  is  legal  tender  at  its  face  value  for  all  debts, 
when  not  below  the  standard  weight  and  limit  of.  tolerance  pre- 


Ill 


STOCK  OF  MONEY 


15 


scribed  by  law;  and  when  below  standard  and  limit  of  tolerance  it 
is  legal  tender  in  proportion  to  its  weight.  Gold  is  now  coined 
into  quarter-eagles  ($2.50),  half-eagles  ($5),  eagles  ($10),  and 
double-eagles  (<S2o).  During  limited  periods  $1  pieces  (1849- 
1889;  1902-1905)  and  $3  pieces  (1854-1889)  were  coined,  but  the 
small  size  of  such  coins  made  them  unacceptable  for  circulation. 

5.  Gold  Dollar  and  Mint  Price  of  Gold. — The  weight  of  the 
gold  dollar  (not  now  coined)  is  25.8  grains,  of  which  nine-tenths, 
or  23.22  grains,  is  pure  gold.  The  difference  in  weight  is  made  up 
of  copper  alloy  in  order  to  give  hardness  to  the  coin.  The  weight 
of  a  new  gold  eagle  or  double-eagle  must  not  vary  more  than  half 
a  grain  from  the  standard  weight  fixed  by  law,  and  that  of  the 
smaller  gold  coins  must  not  vary  more  than  a  quarter  of  a  grain. 
This  allowable  variation  is  called  "tolerance  of  the  mint."  The 
tolerance  in  fineness  cannot  exceed  more  than  i  one-thousandth. 
Coins  are  subject  to  loss  in  weight  owing  to  abrasion;  and  after  a 
circulation  of  twenty  years  and,  at  a  ratable  proportion  of  any 
period  less  than  twenty  years,  the  law  permits  a  deviation-  from 
the  standard  weight  of  1/2  per  cent  without  diminishing  the  legal 
tender  value  of  coins.  If  the  loss  be  more  than  that,  the  coins 
are  legal  tender  in  proportion  to  their  actual  weight.  The  follow- 
ing table  shows  the  standard  weights  and  limits  of  deviation  of 
gold  coins  (20  years  old) : 

Standard  and  Least  Current  Weight  of  Gold  Coins 


Denomination 

Standard  Weight 

in  Grains 
(Nine-tenths  fine) 

Per  Cent 

Abrasion  in  Grains 

(1/2  Per  Cent) 

Least  Current 
Weight  in  Grains 

Double-eagle .... 

Eagle 

Half -eagle 

Quarter-eagle .... 

516.0 
258.0 
129.0 

64.5 

2.58 
1.29 
0.64 
0.32 

51342 

256.71 

128.36 

64.18 

I6  BANKING  AND  CREDIT  [II 

The  mint  price  of  an  ounce  of  pure  or  line  gold  is  $20.67183 
and  of  standard  gold,  $18.60465.  These  two  values  are  deter- 
mined by  dividing  the  number  of  grains  in  a  troy  ounce  by  the 
number  of  grains  of  gold  in  the  standard  gold  dollar,  thus: 

480  -T-  23.22  =  20.67183 
and 

480  -i-    25.8    =    18.60465 

The  mint  price  of  gold  is  simply  a  quantity  relationship  between 
gold  in  the  form  of  bullion  and  gold  in  the  form  of  coins,  and 
represents  the  number  of  dollars  that  physically  can  be  made 
from  an  ounce  of  metal.  Obviously  this  ratio  is  bound  to  remain 
fixed  so  long  as  the  coinage  laws  are  unchanged.  The  factors 
determining  the  mint  price  of  gold  are  thus  essentially  different 
from  those  determining  the  price  of  wheat  or  other  commodities. 
The  price  of  wheat  does  not  mean  the  number  of  bushels  of  wheat 
that  a  given  quantity  will  command  in  the  market  but,  instead, 
the  amount  of  a  second  article,  and  in  particular  the  monetary 
medium. 

6.  Coinage  Charges. — The  government  mints  receive  and 
immediately  pay  for  all  gold  bullion  of  standard  fineness  which 
may  be  presented.  No  charge  or  seigniorage  is  made  for  this 
exchange.  If  the  gold  be  below  the  standard  of  fineness,  a  charge 
is  made  for  parting  (the  separation  from  silver)  or  refining  (the 
elimination  of  base  metal).  The  rates  of  these  charges  are 
prescribed  by  the  Director  of  the  Mint  and  vary  from  1/2  cent 
per  ounce  to  4  cents  per  ounce,  according  to  the  purity  of  the 
bullion.  Deposits,  however,  containing  800  thousandths  or  more 
of  base  metal  are  declined,  and  no  charge  is  made  for  bullion  con- 
taining 9.92  thousandths  of  gold  and  upward.  A  charge  of  2  1/2 
cents  per  ounce  for  the  copper  alloy  is  also  made,  the  amount  to 


II]  STOCK  OF  MONEY  17 

be  calculated  as  one-ninth  of  the  fine  weight  of  the  gold.^  Accord- 
ing to  the  convenience  of  the  mint,  the  bullion  so  received  may  be 
converted  into  coin  or  carried  as  gold  bullion  in  the  general  fund 
of  the  Treasury  or  in  the  reserve  of  the  Treasury  against  certifi- 
cates or  legal  tender  notes.  The  provision  allowing  bullion  to  be 
carried  against  gold  certificates  dates  only  from  igii;  prior  to 
that  date  all  bullion  was  carried  in  the  general  fund.  Gold  coin 
will  be  delivered  to  any  apphcant  by  the  Treasury  for  gold 
certificates,  United  States  notes,  treasury  notes  of  1890,  or 
federal  reserve  notes,  the  consignee  paying  the  transportation 
charges. 

Foreign  gold  coins  which  come  into  this  country  are  generally 
melted  into  bars  and  subsequently  coined  into  United  States  coins. 
Although  a  law  was  enacted  in  191 1  permitting  the  Treasury 
Department  to  carry  a  certain  amount  of  foreign  gold  coin  in  its 
reserve  fund  against  which  gold  certificates  may  be  issued,  im- 
porters of  foreign  coin  frequently  do  not  find  it  profitable  to  dis- 
pose of  the  gold  to  the  Treasury,  for  when  the  foreign  coins  are 
presented  there  is  a  heavy  deduction  for  tolerance,  abrasion,  or 
light-weight  coins.  Importers  of  coin  therefore  may  prefer  to 
turn  the  coin  into  the  assay  office  where  they  get  more  as 
bullion. 

For  the  convenience  of  exporters  and  manufacturers,  gold  is 
made  up  into  bars.  Commercial  gold  bars  range  in  fineness 
from  990  to  999  thousandths  fine,  the  weight  and  fineness  being 
stamped  on  each  bar.  The  mint  exchanges  fine  gold  bars  for  gold 
coin  in  lots  of  not  less  than  $5,000  in  value.  The  bars  range  in 
value  as  follows:  $100,  $200-$300,  $5oo-$6oo,  and  $5,000.  As 
the  loss  by  abrasion  of  coins  is  to  be  considered,  exporters  of  gold 
generally  prefer  the  use  of  bars. 

For  the  work  of  refining,  assaying,  and  coinage,  the  govern- 
ment operates  several  mints.    There  are  coinage  mints  at  Phila- 


*  See  Problem  i,  Appendix  A,  for  example  of  calculation. 


i8 


BANKING  AxND  CREDIT 


II 


delphia,  San  Francisco,  and  Denver;  mints  at  New  Orleans  and 
Carson  City  conducted  as  assay  offices;  and  assay  offices  at  New 
York,  Seattle,  Boise,  Helena,  Salt  Lake  City,  and  Deadwood; 
these  latter  are  bullion  purchasing  agencies  for  the  mints.  Re- 
fineries are  operated  at  New  York,  San  Francisco,  and  Denver 
institutions. 

7.  Gold  Stock. — The  United  States  holds  a  very  considerable 
part  of  the  world  stock  of  gold  available  for  money.  In  the  year 
before  the  outbreak  of  the  Great  War  nearly  one-quarter  (23  per 
cent)  was  credited  to  this  country,  and  during  the  war  period 
the  gold  money  stock  of  the  United  States  further  increased.  As 
the  world  production  of  gold  fell  off  and  gold  imports  were  large, 
the  proportion  held  by  the  United  States  in  1920  was  swollen  to 
about  a  third  of  the  total  world  stock. 

The  ten  countries  holding  the  largest  amounts  of  gold  in  191 8 
were:^ 

Gold  Holdings  of  Several  Countries 


Country 

Amount 

(■Millions) 

Per  Capita 

United  States 

$3,165* 
720 
664 
539 
439 
391 
322 
278 
234 
131 

$30.14 
15.61 
16.73 

7-95 
21.39 

6.99 
3990 
42.22 

6.41 
16.21 

Great  Britain 

France 

Germany ." 

Spain 

Japan 

Argentina 

Netherlands 

Italy 

Canada 

Between  1918  and  192 1  the  share  of  the  United  States  slightly  decreased. 


3  Report  of  the  Director  of  the  Mint,  1919,  p.  282. 


II]  STOCK  OF  MONEY  19 

The  possession  of  a  large  fraction  of  the  world's  gold  mone- 
tary stock  does  not  necessarily  imply  that  a  country  is  in  a 
superior  financial  position.  As  will  be  subsequently  seen,  gold  is 
the  basis  of  credit  money,  and  if  the  credit  instruments  and  in- 
stitutions be  wisely  organized,  a  small  amount  of  gold  may  be  as 
effective  as  a  larger  amount  in  supporting  the  financial  operations 
of  a  nation.  Spain  in  1918,  it  will  be  observed,  had  more  gold 
per  capita  than  Great  Britain  or  Japan. 

The  significance  of  this  stock  of  gold  in  terms  of  physical 
measurement  is  of  interest.  A  cubic  foot  of  gold  is  worth  $363 ,180. 
If  the  world's  gold  monetary  stock  be  estimated  at  $9  billion  it 
would  occupy  a  space  of  24.781  cubic  feet.  This  represents  a 
room  about  50  feet  square  and  10  feet  in  height. 

8.  Production  of  Gold. — The  total  product^'^^n  of  gold  since 
1492  is  estimated  (1919)  at  $17,765  million  (859  million  fine 
ounces).  A  considerable  amount  of  gold  goes  into  the  industrial 
arts  and  some  has  been  lost  or  worn  out.  The  following  table 
shows  the  world's  production  since  1492  -J 

World  Production  of  Gold  since  1492 


Period 

Value 

I 493- I 600 

$501,640,000 

1601-1700 

606,315,000 

1701-1800 

1,262,805,000 

180T-1900 

7,695,570,000 

1901-1919 

7,698,934,000 

Total 

$17,765,264,000 

As  much  gold  was  mined  in  the  first  twenty  years  ot  this 
century  as  in  the  previous  one  hundred  years.  Since  1900  the 
annual  value  of  the  gold  product  of  the  world  and  of  the  United 
States  is  estimated  as  follows  :s 


*  Report  of  the  Director  of  the  Mint,  1920,  p.  294. 

5  Statistical  Abstract  of  United  States,  1920,  pp.  800,  822. 


20 


BANKING  AND  CREDIT 


II 


Annual  Gold  Production  since  1900 
(In  millions) 


Year 

World 

U.  S. 

Year 

World 

U.  S. 

1901 

$261 

?79 

1911 

$462 

$97 

1902 

297 

80 

1912 

466 

93 

1903 

328 

74 

1913 

460 

88 

1904 

347 

80 

1914 

439 

95 

1905 

380 

88 

1915 

469 

lOI 

1906 

403 

94 

1916 

454 

93 

1907 

413 

90 

1917 

419 

84 

1908 

443 

95 

1918 

384 

69 

1909 

454 

TOO 

1919 

365 

60 

1910 

455 

96 

1920 

325 

50 

For  several  years,  1909-1916,  the  annual  product  was  over 
$450  million.  Disturbances  caused  by  war  and  the  increased  cost 
of  labor  and  supplies  entering  into  mining  caused  a  decline,  showing 
a  production  in  1920  of  $325  million,  a  decrease  of  nearly  one-third. 

The  annual  production  from  our  owm  mines,  including  Alaska, 
is  about  one-iifth  of  the  total  world's  supply.  The  gain  which  the 
United  States  has  made  in  gold  stock  in  the  past  few  years  has 
been  largely  due  to  imports,  as  seen  in  the  following  table: 


Imports  and  Exports  of  Gold,  1901-1920 

(In  millions) 


Exports 

Imports 

Excess  of 

Years 

Exports  over  Imports 

Imports  over  Exports 

1901-1905 

I322.9 

$316.8 

$6.1 

1906-1910 

372.5 

446.4 

$73-9 

1911-1915 

4159 

429.9 

14.0 

1916-1920 

1,282.9 

2,101.1 

818.2 

II I  STOCK  OF  MONEY  21 

In  a  period  of  rising  prices  no  relief  can  be  given  to  the  gold- 
mining  industry  by  increasing  the  mint  price  of  gold.  It  is  under- 
stood, of  course,  that  the  country  will  depart  in  no  way  from  its 
gold  standard.  Suppose  that  the  mint  price  were  increased  from 
approximately  $20  to  $40  per  ounce.  The  gold  content  of  the 
dollar  and  hence  its  purchasing  power  would  be  halved.  Prices 
would  be  thus  doubled  but  the  purchasing  power  of  gold  per 
fixed  unit,  as  an  ounce,  would  not  be  changed,  so  that  the  net 
effect  would  be  nil. 

9.  Proposals  to  Encourage  Gold  Mining. — Although  an 
enormous  mass  of  gold  has  been  mined  in  the  past  hundred  years 
as  compared  with  previous  centuries,  and  the  annual  world  pro- 
duction during  the  past  twenty-five  years  has  been  far  greater 
than  during  the  period  of  the  notable  discoveries  in  California 
and  Australia  in  the  middle  of  the  nineteenth  century,  the  present 
decline  in  the  annual  yield  is  regarded  by  some  as  a  serious  danger. 
A  decrease  naturally  affects  adversely  those  engaged  in  the  gold- 
mining  industry.  Apart  from  this  it  is  held  to  be  a  matter  of 
public  concern,  since  gold  is  the  standard  of  value,  is  the  final 
basis  of  credit,  and  is  in  universal  demand  for  banking  reserves. 
Indebtedness,  both  public  and  private,  is  legally  payable  in  gold 
coin  of  the  present  weight  and  fineness.  New  countries  in  the 
past  half-century  have  changed  from  a  silver  to  a  gold  standard, 
thus  increasing  the  strain.  There  has  been  also  a  worldwide 
increased  use  of  gold  in  the  industrial  arts.  The  world  production 
in  1919,  due  largely  to  rising  costs,  was  less  than  in  any  year  since 
1904.  Production  in  the  United  States  declined  from  vSioi 
million  in  191 5  to  $50  miUion  in  1920,  while  the  industrial  con- 
sumption increased.  For  jewelry,  gold  leaf,  gold  plate,  and  for 
purposes  of  ornament  and  decoration  it  is  estimated  that  the 
world  is  now  using  more  than  three  times  as  much  gold  as  was 
produced  from  the  mines  of  the  world  in  1840. 

There  is  no  law  in  the  United  States,  as  exists  in  most  coun- 


22  BANKING  AND  CREDIT  [II 

tries,  against  the  melting  of  coin  for  industrial  use.  Manu- 
facturers in  other  countries  therefore,  who  would  be  obliged  to 
pay  a  premium  in  order  to  divert  gold  from  their  own  mints,  may 
find  it  more  profitable  to  buy  gold  coin  in  this  country.  To  pro- 
tect our  gold  stock  and  also  to  encourage  gold  mining,  it  has  been 
proposed  that  gold-miners  be  paid  a  premium  of  $io  for  every 
fine  ounce  produced,  and  that  an  excise  duty  of  an  equal  amount 
be  laid  on  the  use  or  sale  of  gold  in  the  United  States  for  other 
than  monetary  purposes.  Under  this  arrangement  it  is  claimed 
that  the  tax  would  yield  sufficient  revenue  to  pay  the  premiums 
granted  as  a  mining  subsidy. ''  Such  proposals,  however,  have 
received  but  little  support.  With  the  readjustment  of  industry 
and  technical  improvements  in  the  extraction  of  gold  it  is  prob- 
able that  the  gold  product  will  increase  in  the  near  future. 

ID.  Silver  Dollars. — Until  1873  the  coinage  of  silver  dollars 
like  that  of  gold  coins  was  unrestricted,  but  in  the  coinage  act  of 
that  year  this  privilege  was  omitted.  Silver  dollars  had  pre- 
viously disappeared  from  use,  since  silver  as  bullion  was  worth 
more  than  the  mint  offered  at  the  prevailing  bimetallic  ratio. 
But  about  the  same  time  a  sudden  drop  took  place  in  the  value 
of  silver,  due  to  new  supplies  in  the  United  States  and  the  sale  of 
silver  by  Germany,  which  adopted  a  single  gold  standard.  Prices 
of  commodities  were  also  falling,  and  farmers,  particularly  in  the 
West,  claimed  that  this  was  due  to  a  contraction  of  the  currency. 
Asaresiiltof  this  agitation  the  Bland  Act  (1878-1890)  was  passed, 
authorizing  the  purchase  of  a  limited  amount  of  silver  to  be 
coined  into  dollars;  and  the  Sherman  Act  (1890-1893)  increased 
this  amount.  Only  indirectly,  however,  did  the  purchases  under 
the  latter  statute  result  in  the  coinage  of  dollars:  the  purchases 
of  silver  were  made  by  the  issue  of  treasury  notes,  the  bullion 
being  held  for  coinage  if  needed  for  the  redemption  of  the  notes. 


^  See  Our  Vanishing  Gold  Reserve,  a  pamphlet  published  by  the  American   Mining 
Congress,  191Q,  Washington. 


II  ]  STOCK  OF  MONEY  23 

Shortly  after  the  Gold  Standard  Act  of  1900  these  treasury  notes 
were  retired  (less  than  $2  million  now  outstanding)  and  the 
bullion  previously  purchased  coined  into  dollars  and  subsidiary 
silver  coins.  When  this  was  accomplished  the  coinage  of  silver 
dollars  ceased  (1904). 

Silver  dollars  are  legal  tender  to  any  amount.  The  weight  of 
the  coin  is  412  1/2  grains,  nine-tenths  line,  or  371  1/4  grains  of 
pure  silver.  The  bullion  value  of  a  silver  dollar  is  determined  by 
dividing  the  product  of  371.25,  multiplied  by  the  market  price  of 
silver  per  ounce,  by  480  (the  number  of  grains  in  a  troy  ounce). 
Thus  if  the  market  quotation  for  silver  is  68  1/8  cents  per  ounce: 

371.25  X  68  1/8 

=  52.7  cents 

480 

Except  for  a  few  months  in  1919  and  1920  the  bullion  value  of 
a  silver  dollar  since  1873  has  been  less  than  a  dollar  in  gold,  and 
during  the  ten  years  subsequent  to  1893  its  bullion  value  was  less 
than  50  cents.  In  1902  it  fell  to  $0,367;  in  other  words,  a  dollar 
in  gold  would  buy  1,011.16  grains  of  pure  silver,  as  compared  with 
371  1/4  grains  of  silver  if  it  had  not  depreciated  in  value.  As  the 
Treasury  bought  the  silver,  both  under  the  Bland  Act  of  1878  and 
Sherman  Act  of  1890,  at  its  bullion  value,  a  large  amount  of 
seigniorage  or  profit  was  made.  During  the  entire  period,  1878- 
1904,  this  amounted  to  $1 18  million  on  a  coinage  of  $570  million. 

During  the  period  of  the  recent  war  the  value  of  silver  rose, 
and  an  act  (the  Pittman  Act)  was  passed  April  23,  1918,  authoriz- 
ing the  government  to  melt  and  sell  as  bullion  $350  million  of 
silver  dollars^  at  a  price  to  be  determined  by  the  Treasury,  but 
not  less  than  $1  per  ounce  of  silver  i  ,000  fine.  Under  the  author- 
ity of  this  act  about  208  million  fine  ounces  were  sold  to  the  British 
government  for  use  in  India.  As  a  result  the  stock  of  silver  dollars 
decreased.  The  decrease,  however,  will  not  be  permanent,  for  the 
Pittman  Act  provides  that  domestic  silver  be  repurchased  to 

7  Federal  Reserve  Bulletin,  1918,  Vol.  IV,  p.  395. 


24  BANKING  AND  CREDIT  [11 

replace  the  dollars  melted,  at  a  fixed  price  of  $i  per  ounce.  In 
1920  the  mint  service  began  the  purchase  of  silver,  and  in  the 
following  year  its  coinage  into  silver  dollars,  to  replace  those 
melted  down  under  the  Pittman  Act.  The  price  of  foreign  silver 
fell  in  1920  to  much  less  than  $1  an  ounce,  but  because  of  the 
preference  given  to  domestic  silver  for  the  needs  of  the  mint,  the 
price  of  the  latter  is  approximately  $1  and  will  remain  so  until 
the  replacement  has  been  made. 

11.  Subsidiary  Silver.— Until  1853,  the  coinage  of  subsidiary 
silver  coins  (half-dollars,  quarter-dollars,  dimes,  and  half-dimes) 
was  free;  the  coins  were  proportionate  in  weight  to  the  silver 
dollar  and  they  were  legal  tender  in  any  amount.  In  1853,  owing 
to  the  rising  value  of  silver  in  the  silver  bullion  market  which  led 
to  the  melting  of  coins,  the  weight  of  the  coins  was  reduced — the 
half-dollar  from  206.25  grains  to  192.9  grains,  and  the  quarters 
and  dimes  proportionately.  By  this  change  it  was  unprofitable 
to  melt  the  coins.  In  coinage  the  tolerance  in  weight  permitted 
is  1.5  grains  and  the  deviation  in  fineness,  3  thousandths.  Sub- 
sidiary silver  is  now  legal  tender  for  payments  up  to  $10.  Its  coin- 
age is  not  free  but  the  mint  purchases  silver  in  the  open  market 
and  mints  coins  in  denominations  according  to  public  demand. 
Upon  deposit  of  other  funds,  the  Treasury  ships  the  coins  to 
the  applicant,  the  consignee  paying  transportation  charges. 

12.  Minor  Coins. — The  current  minor  coins  are  the  i  cent 
bronze,  made  of  95  per  cent  copper  and  5  per  cent  tin  and  zinc, 
and  the  5  cent  nickel,  made  of  75  per  cent  copper  and  25  per  cent 
nickel.  The  outstanding  minor  coinage  is  approximately  $87 
million.  Though  of  considerable  amount,  it  is  not  included  in  the 
official  statements  of  the  stock  of  money  in  the  United  States, 
These  coins  are  legal  tender  up  to  25  cents  in  any  one  payment. 
They  are  shipped  by  the  mint  upon  application,  the  consignee 
paying  the  cost  of  transportation. 


II]  STOCK  OF  MONEY  25 

13.  Gold  and  Silver  Certificates. — Gold  and  silver  certificates 
do  not  add  to  the  total  stock  of  money.  They  circulate  in  place 
of  coin  which  to  an  equal  amount  is  held  in  trust  by  the  Treasury. 
They  are  simply  ''warehouse  receipts,"  used  as  a  convenient 
substitute  for  the  heavier  coin.  Their  use  also  saves  loss  by 
abrasion  of  coins. 

Gold  certificates  are  issued,  upon  deposit  of  gold  coin,  bullion, 
and  foreign  coin,  in  denominations  ranging  from  $10  to  $10,000. 
The  larger  denominations  are  of  special  advantage  in  making 
bank  settlements.  In  the  past  few  years,  due  to  the  development 
of  the  federal  reserve  banking  system,  there  has  been  a  marked 
decline  in  the  amount  of  gold  certificates.  At  the  close  of  1916 
there  were  $1,224  million  in  circulation.  With  the  absorption  of 
gold  by  the  federal  reserve  bank,  gold  was  used  for  security  of  the 
new  federal  reserve  notes  which  began  to  be  freely  issued  in  191 7. 
As  a  result  the  supply  of  gold  certificates  in  four  years  decreased 
by  more  than  half.  Although  gold  certificates  represent  100  per 
cent  of  gold  specifically  lodged  with  the  Treasury  for  their  re- 
demption, they  were  not  made  legal  tender  until  December  24, 
1919. 

Silver  certificates  are  issued  in  denominations  between  $1 
and  $100  upon  deposit  of  silver  dollars.  Silver  certificates  are 
not  a  legal  tender,  but  are  receivable  for  all  public  dues  and  taxes. 

14.  United  States  Notes. — Aside  from  the  gold  and  silver 
certificates  and  treasury  notes  of  1890,  there  are  four  varieties  of 
paper  currency  in  circulation:  United  States  notes,  national  bank 
notes,  federal  reserve  notes,  and  federal  reserve  bank  notes. 

The  United  States  notes,  sometimes  called  ''greenbacks"  or 
"legal  tenders, "  are  an  inheritance  of  the  Civil  War.  Since  1878 
the  amount  outstanding  has  been  $346,681,016.  The  notes  are 
legal  tender  in  payment  of  all  debts,  public  and  private,  except 
duties  on  imports  and  interest  on  the  public  debt.  These  excep- 
tions, which  have  little  practical  significance  now,  were  introduced 


26  BANKING  AND  CREDIT  [II 

into  the  original  law  in  order  to  make  certain  that  the  government 
had  a  gold  fund  from  custom  duties  and  to  reassure  the  buyers 
of  bonds  that  their  interest  would  not  be  paid  in  depreciated 
currency.  Notes  are  issued  in  denominations  of  from  $i  to$i,ooo, 
but  the  larger  part  are  in  the  smaller  denominations  of  $i,  $2, 
and  $5 .  Against  these  notes  there  is  a  gold  reserve  of  $1 50  million, 
or  about  45  per  cent.  The  power  of  Congress  to  make  paper 
currency  legal  tender  was  early  contested  in  the  courts.  At  first 
the  Supreme  Court  decided  adversely,  but  later  the  decision  was 
reversed  and  their  constitutionality  affirmed. 

It  is  frequently  proposed  that  these  notes  be  retired,  on  the 
ground  that  the  government  should  not  in  normal  times  give 
sanction  to  the  circulation  of  promissory  notes  having  a  legal 
tender  quality.  In  opposition,  however,  it  is  urged  that  as  these 
notes  are  mostly  in  small  denominations  serving  as  pocket  money, 
if  retired,  bills  of  other  forms  would  be  needed.  Moreover,  fund? 
raised  by  taxation  would  have  to  be  provided  for  their  redemption. 

15.  National  Bank  Notes. — These  notes  also  have  their  origin 
in  the  legislation  of  the  Civil  War  period.  Hitherto  notes  were 
issued  by  hundreds  of  state  banks.  Many  of  these  were  sound 
and  their  credit  good.  Failures,  however,  were  frequent  and  in 
some  of  the  states  the  protection  given  to  holders  of  notes  issued 
was  inadequate.  Counterfeiting  also  was  easy  when  there  was  a 
great  variety  of  notes.  But  more  powerful  than  any  other  reason 
was  the  desire  to  stimulate  the  purchase  of  government  bonds, 
by  the  establishment  of  a  national  banking  system,  whereby 
institutions  were  granted  the  privilege  of  note  issue  based  upon 
the  deposit  of  government  bonds.  In  order  to  force  banks  desiring 
the  privilege  of  note  issue  into  the  national  system,  a  heavy  tax 
was  placed  on  the  notes  of  all  state  banks.  The  issue  of  national 
bank  notes,  notwithstanding  the  recent  estabhshment  of  the 
federal  reserve  banking  system  with  note-issuing  powers,  has 
continued  to  the  present  time,  and  these  notes  constitute  an  im- 


II]  STOCK  OF  MONEY  27 

portant  part  of  the  circulating  medium.  The  principal  fact  to 
observe  here  is  that  the  issue  of  these  notes  is  inelastic,  being  de- 
termined by  the  deposit  of  certain  classes  of  government  bonds 
which  are  limited  in  volume  and  which  must  be  previously  pur- 
chased at  the  market  price. 

The  Federal  Reserve  Act  plans  for  the  gradual  retirement  of 
these  notes,  but  the  demands  of  recent  war  financiering  have  de- 
layed the  carrying  out  of  this  intent  and  it  seems  probable  that 
the  national  banking  currency  will  remain  a  part  of  the  circulating 
medium.  The  amount  in  circulation  January  i,  192 1,  was  $708 
million,  as  compared  with  the  maximum  in  1915  of  $785  million. 
National  bank  notes  are  not  a  legal  tender  but  are  receivable  by 
the  government  for  all  public  dues  except  duties  on  imports. 
Moreover,  each  national  bank  must  receive  the  notes  of  all  other 
national  banks  at  par. 

16.  Federal  Reserve  Notes. — The  federal  reserve  notes  con- 
stitute by  far  the  largest  part  of  the  paper  currency  at  the  present 
time,  amounting  in  1920  to  more  than  two- thirds  of  the  total 
paper  currency.  These  notes  are  issued  through  the  twelve 
federal  reserve  banks,  secured  by  certain  classes  of  commercial 
paper,  bills  of  exchange,  acceptances,  gold  or  gold  certificates. 
Inasmuch  as  the  volume  of  commercial  paper  and  bills  of  ex- 
change changes  with  the  fluctuation  in  business  enterprise,  the 
note-issuing  power  is  elastic. 

17.  Federal  Reserve  Bank  Notes. — The  federal  reserve  bank 
notes  constitute  but  a  slight  portion  of  the  currency.  Under  the 
Federal  Reserve  Act  of  19 13  the  federal  reserve  banks  were  given 
authority  to  issue  federal  reserve  bank  notes  secured  by  United 
States  bonds,  which  they  purchased  from  national  banks  in  ac- 
cordance with  a  plan  of  ultimate  retirement  of  national  bank 
notes.  It  was  not  intended  that  the  notes  should  play  a  perma- 
nent part  in  the  currency  system.    By  subsequent  amendments 


28  BANKING  AND  CREDIT  [II 

they  were  also  issued  upon  the  pledge  of  United  States  certifi- 
cates of  indebtedness,  or  i-year  gold  notes;  and  in  1918  their  issue 
was  further  extended  to  take  the  place  of  silver  certificates  called 
in  from  circulation  when  silver  dollars  were  melted  and  sold  as 
bullion  under  the  Pittman  Act. 

18.  Amounts  of  Different  Kinds  of  Money. — From  the  fore- 
going description  it  will  be  seen  that  a  great  variety  of  monetary 
instruments  has  been  used  at  different  periods.  This  is  more 
clearly  shown  in  the  table  on  page  29. 

This  table  may  be  further  condensed  to  show:  (i)  gold,  in- 
cluding gold  certificates;  (2)  silver,  including  silver  certificates; 
(3)  government  promissory  notes,  including  United  States  notes, 
treasury  notes  of  1890,  and  currency  certificates;  (4)  national 
bank  notes,  including  federal  reserve  bank  notes;  (5)  federal 
reserve  notes;  and  (6)  subsidiary  silver  coins.     (See  page  30.) 

19.  Credit  Forms  of  Money. — The  value  of  all  the  forms  of 
money  listed  in  the  above  tables,  except  gold  and  gold  certificates, 
depends  in  some  degree  upon  credit.  The  United  States  notes 
are  promises  of  the  government  and  are  supported  by  its  credit, 
reinforced  by  a  partial  gold  reserve;  the  national  bank  notes  and 
federal  reserve  bank  notes  are  secured  by  government  obligations 
which  are  simply  promises  of  the  government  to  pay  to  the  holders 
of  the  bonds  at  some  designated  date  the  debt  due;  and  the 
federal  reserve  notes  are  secured  by  commercial  paper  (notes  and 
bills  of  exchange) ,  also  backed  up  by  a  partial  gold  reserve.  The 
position  of  the  silver  dollar  is  not  so  clear.  It  is  technically  stand- 
ard money,  but  its  bullion  value  is  less  than  its  face  value.  The 
Gold  Standard  Act  of  1900,  however,  pledges  the  government  to 
maintain  "all  forms  of  money  issued  or  coined  by  the  United 
States"  at  a  parity  with  gold. 

20.  Changes  in  Composition  of  Monetary  Medium. — The 
table  on  page  29  shows  that  there  have  been  marked  changes  in 


II 


STOCK  OF  MONEY 


29 


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BANKING  AND  CREDIT 


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II]  STOCK  OP  MONEY  31 

the  composition  of  the  monetary  medimn.  Government  credit 
notes  have  diminished  to  a  small  proportion;  silver  is  of  slight 
importance;  bank  notes  based  upon  bonds,  though  increasingly 
large  in  amount,  are  a  smaller  percentage  of  the  total;  and  gold  in 
circulation  declined  from  44.9  per  cent  in  1910  to  20.2  per  cent 
in  1920.  The  new  form  of  credit  money,  federal  reserve  notes  in 
1920,  constitutes  more  than  half  the  circulation.  It  must  not, 
however,  be  assumed  that  the  monetary  system  is  necessarily 
weakened  by  this  change,  for  back  of  the  federal  reserve  notes  is 
an  enormous  mass  of  gold.  In  the  table  on  page  29  this  is  merged 
in  the  last  column,  ''Money  in  the  Treasury,"  which  includes 
gold  held  by  federal  reserve  banks  and  agents  as  reserve  against 
federal  reserve  notes.  Without  this  impounded  gold  the  circula- 
tion of  federal  reserve  notes  would  hardly  be  possible.  To  a  very 
considerable  extent  the  gold  certificates  have  been  retired,  as  seen 
in  the  decrease  between  191 5  and  1920,  and  the  gold  thus  with- 
drawn from  the  Treasury  is  now  held  by  the  federal  reserve  banks 
to  support  the  issue  of  credit  notes  which  these  institutions  are 
making. 

21.  Redemption  of  Moneys. — The  Treasury  Department  is 
continuously  engaged  in  the  exchange  of  moneys  and  in  redeem- 
ing notes  and  the  issue  of  new  ones,  because  the  old  notes  are 
worn  out,  or  notes  of  different  denominations  are  desired,  or  other 
forms  of  money  are  in  demand.  United  States  notes  and  gold 
certificates  are  redeemable  in  gold  coin,  treasury  notes  of  1890 
in  gold  coin  or  silver  dollars,  silver  certificates  in  silver  dollars, 
national  bank  notes  in  lawful  money,  and  federal  reserve  notes 
in  gold  or  lawful  money.  Silver  dollars,  being  standard,  are  not 
redeemable,  but  may  be  exchanged  for  gold  according  to  Treasury 
practice.  Subsidiary  silver  and  minor  coin  in  multiples  of  $20 
may  be  redeemed  in  lawful  money.  During  the  crop  movement 
in  the  latter  part  of  the  year  notes  of  large  denominations  are 
sent  in  for  redemption  in  order  to  secure  small  bills,  while  in  the 


32  BANKING  AND  CREDIT  [  II 

first  half  of  the  year  large  bills  are  in  greater  demand.  The  aver- 
age cost  for  the  issue  of  each  note  of  paper  money,  including  the 
making,  issue,  and  redemption,  is  about  i  1/2  cents  (1.526). 

Paper  currency  in  all  its  different  forms,  when  unfit  for  circula- 
tion— if  not  mutilated  so  that  less  than  three-fifths  of  the  original 
bill  remains — is  redeemable  at  the  face  value  of  the  note.  If  less 
than  three-fifths  but  more  than  two-fifths  remains,  the  note  will 
be  redeemed  at  half  its  face  value,  but  the  presentation  of  any 
fragment  will  secure  redemption  of  full  face  value,  if  accompanied 
by  satisfactory  affidavits  as  to  the  destruction  of  the  missing  por- 
tions. Reimbursement  in  no  case  is  made  for  currency  totally 
destroyed.  Mutilated  and  light  gold  coins  are  not  redeemable  at 
their  face  value,  but  can  be  sold  as  bulHon.  Light  silver  coins, 
however,  are  generally  redeemable  at  their  face  value. 

Banks  are  constantly  on  the  alert  to  detect  counterfeit  money 
and  very  little  remains  long  in  circulation.  When  discovered,  the 
loss  falls  on  the  customer  who  deposited  it;  the  note  is  stamped 
"  Counterfeit "  and  turned  over  to  the  Secret  Service  Department 
of  the  government.  Raised  money  is  more  frequent  than  counter- 
feit. As  banks  sort  bills  by  denominations,  and  each  denomina- 
tion bears  a  different  engraving,  a  raised  note  is  easily  detected. 

References 

Moulton,  H.  G.     Principles  of  Money  and  Banking. 

Coinage  rules  and  regulations  of  the  United  States,  abstract  from 
General  Instructions  and  Regulations  in  Relation  to  the  Transaction 
of  Business  at  the  Mints  and  Assay  Offices  of  the  United  States,  Part 
I,  pp.  81-85. 
Muhleman,  M.  L.     Monetary  Banking  Systems. 

Different  kinds  of  money,  pp.  12-38;  summary  of  legislation  and 
court  decisions  in  regard  to  legal  tender,  pp.  39-45;  table  showing 
characteristics  of  the  different  forms  of  money  current  (1908),  p.  46. 
A  valuable  reference  book  with  precise  information  at  date  of 
publication,  1908. 
United  States.  Bureau  of  Foreign  and  Domestic  Commerce.  Statistical 
Abstract  (Annual). 


II]  STOCK  OF  MONEY  33 

United  States.     Bureau  of  the  Mint.     Annual  Reports  of  the  Director. 
Statistics  of  gold  production,  also  reproduced  in  the  Statistical 
Abstract. 

Treasury  Department.     Annual  Report  of  the  Secretary  on  the  State 

of  the  Finances. 

Treasury  Department.     Circulation  Statement. 

Statistics  of  stock  of  money  and  money  in  circulation,  and  gold 
production,  published  monthly.  These  are  compiled  in  tables  running 
over  a  period  in  the  Annual  Report  but  more  conveniently  presented 
in  the  Statistical  Abstract. 
Westerfield,  R.  B.     Banking  Principles  and  Practice. 

A  standard  recent  description  and  discussion  on  coinage,  Vol.  I, 
pp.  18-34. 

Note:  Problems  1-7,  with  solutions,  in  Appendix  A  of  this  volume  should 
be  consulted. 


CHAPTER  III 

COMMERCIAL  CREDIT  INSTRUMENTS 

1.  The  Use  of  Commercial  Credit  Instruments. — The  conduct 
of  modern  business  has  made  indispensable  the  use  of  certain 
credit  instruments  which  serve  as  media  of  exchange.  They  make 
possible  the  purchasing  of  merchandise  on  deferred  payments, 
facilitate  the  borrowing  of  money  to  meet  current  operating 
needs,  and,  in  general,  play  a  large  part  in  the  financial  operations 
of  commercial  transactions.  Settlements  may  be  effected  be- 
tween one  person  and  another  by  a  bill  of  exchange  in  its  variety 
of  forms,  such  as  a  check,  a  draft,  or  an  acceptance;  by  a  promis- 
sory note;  by  a  postal,  express,  telegraphic,  or  bank  money-order; 
or  by  a  certificate  of  deposit. 

Commercial  credit  instruments  are  to  be  distinguished  from 
investment  credit  instruments:  the  former  come  into  existence 
largely  in  the  borrowing  of  working  capital  and  the  financing  of 
merchandise  sales  on  credit;  the  latter  are  chiefly  stocks,  bonds, 
and  short-term  notes,  whose  function  is  to  provide  a  medium  for 
securing  funds  for  fixed  capital  requirements.  Commercial  credit 
instruments  are  also  to  be  differentiated  from  commercial  credit 
documents  as  bills  of  lading  or  warehouse  receipts;  the  former  are 
payable  in  money  while  the  latter  serve  principally  as  evidence 
of  title  to  or  rights  in  goods. 

2.  Definition  of  Bill  of  Exchange. — The  term  "bill  of  ex- 
change" is  used  in  a  broad  sense  to  refer  to  a  written  order  to 
pay  money,  when  drawn  in  proper  form.  According  to  the  Uni- 
form Negotiable  Instruments  Law  a  bill  of  exchange  is  defined  as 
"an  unconditional  order  in  writing  addressed  by  one  person  to 
another,  signed  by  the  person  giving  it  (called  drawer)  requiring 

34 


Ill  ]  COMMERCIAL  CREDIT  INSTRUMENTS  35 

the  person  to  whom  it  is  addressed  (called  drawee)  to  pay  on 
demand  or  at  a  fixed  or  determinable  future  time  a  sum  certain 
in  money  to  order  or  to  bearer."  This  definition  contains  a  brief 
statement  of  the  requirements  to  which  an  instrument  must 
conform  if  it  is  to  be  a  negotiable  bill.  A  written  order  to  pay 
money  which  fails  to  comply  with  all  of  these  conditions  cannot 
properly  be  called  a  bill  of  exchange,  but  it  is  not  correct  to  assume 
that  any  precise  formula  of  words  or  special  phraseology  is  neces- 
sary to  constitute  a  legally  valid  bill. 


No.  701  ■«  Boston.  Mass.,  Jan.  iS.  19  22 

8 

0^    - 
Sixty  days  ~<,  of  fo».  sight 


after "'"'"' pay  to  the  order  of 


Seventh  National  Bank 


&  '"'  •*     O 
One  hundred.omd  '^'irin-five  Dollars  «  735  oo 

< — i-^. ■ — ■ ^— ^ — 

Value  received  andj^harge  the  same  to  the  account  of 

To  A.B.  Curtis  ^  3     2  D.E.  Foster 


Form  I.     Bill  of  Exchange  Drawn  at  60  Days 

A  specimen  bill  of  exchange  is  given  in  Form  i.  The  three 
parties  to  this  instrument  are:  D.  E.  Foster,  the  drawer;  A.  B. 
Curtis,  the  drawee  ;  Seventh  National  Bank,  the  payee. 

In  the  specimen  given  omission  of  the  last  clause,  "Value 
received  and  charge  the  same  to  the  account  of, "  would  have  no 
legal  effect  on  the  instrument,  at  least  in  those  states  where  the 
Uniform  Negotiable  Instruments  Law  is  in  force. 

Checks  are  merely  a  special  class  of  bills  of  exchange.  The 
term  "draft,"  while  having  no  fixed  legal  or  commercial  signifi- 
cance, is  generally  used  synonymously  with  "bill  of  exchange." 
Discussion  of  documentary  bills,  sight  bills,  and  time  bills,  bills 
under  a  bank  credit,  sight  bills  drawn  on  a  foreign  country,  and 
various  other  types  of  drafts  will  be  taken  up  shortly. 


36  BANKING  AND  CREDIT  [III 

3.  Parties  to  a  Bill  of  Exchange. — First,  may  be  considered 
briefly  the  legal  relations  of  the  three  parties  to  a  bill  of  exchange: 
the  drawer,  the  drawee,  and  the  payee.  The  drawer,  or  the  party 
who  makes  out  the  order,  directs  the  drawee  to  pay  a  specified 
sum  of  money.  However,  the  mere  written  order  of  the  drawer 
does  not  make  the  bill  binding  upon  the  drawee,  even  if  the  latter 
owes  the  drawer  the  sum  of  money  called  for  in  the  instrument. 
The  drawee  does  not  become  legally  bound  to  the  holder  or  payee 
until  he  has  taken  formal  action  to  adopt  the  bill  as  his  own 
obligation,  which  act  is  known  as  the  "acceptance."  According 
to  the  Uniform  Negotiable  Instruments  Law,  acceptance  consists 
in  the  drawee's  giving  his  written  assent  to  the  order  of  the  drawer. 
This  is  accomplished  ordinarily  by  writing  or  stamping  the  word 
"Accepted"  with  the  date  and  his  signature  (generally  written 
across  the  face  of  the  bill  on  the  left-hand  end  of  the  paper). 

The  word  "acceptance"  is  used  in  commercial  practice  to 
designate  three  different  things:  (i)  the  act  of  the  drawee  in 
assuming  the  obligation  contained  in  the  instrument  by  giving 
hiswrittenassenttotheorder  of  the  drawer;  (2)  the  written  words 
added  to  the  bill;  and  (3)  the  bill  itself  after  acceptance.  The 
word  "acceptance"  is  the  most  commonly  used  term  for  an  ac- 
cepted bill.  In  the  specimen  of  a  60  days'  bill  already  shown 
(Form  i)  A.  B.  Curtis  is  the  acceptor  and  the  bill  is  known  as 
A.  B.  Curtis'  acceptance. 

The  payee  is  the  person  (individual,  bank,  firm,  or  corpora- 
tion) to  whom  the  drawer  has  ordered  the  payment  of  money  to 
be  made.  This  person  may  be  either  the  original  payee  named 
in  the  instrument  or  some  party  to  whom  the  original  payee  has 
transferred  the  bill.  When  the  drawee  makes  payment  on  the 
bill  to  the  payee,  he  discharges  his  debt  to  the  drawer  by  the  sum 
he  has  so  paid.  It  is  evident  that  he  cancels  his  obligation,  not 
by  direct  payment  to  his  original  creditor  but  by  a  payment  to  a 
third  party  named  in  the  original  creditor's  written  order. 

In  the  specimen  60  days'  sight  bill,  the  clause,  "Pay  to  the 


Ill  ]  COMMERCIAL  CREDIT  INSTRUMENTS  37 

order  of  the  Seventh  National  Bank, "  has  the  same  legal  signi- 
ficance as  "  Pay  to  the  Seventh  National  Bank  or  order."  When 
a  drawer  makes  out  a  bill  payable  to  a  bank  it  is  customary  for  the 
bank  either  to  buy  the  bill  for  a  sum  of  present  cash  somewhat  less 
than  the  face  value  of  the  instrument,  or  to  receive  it  "for  col- 
lection." 

A  bill  of  exchange  may  be  drawn  to  the  order  of  the  drawer 
instead  of  a  third  person,  payable  to  "myself"  or  "ourselves." 
This  is  a  convenient  form  if  at  the  time  the  instrument  is  drawn 
it  is  not  certain  to  whom  it  is  to  be  sold  or  transferred .  To  become 
negotiable  it  must  be  indorsed  by  the  drawer,  who  can  make  it 
payable  to  anyone  he  wishes. 

4.  Classes  of  Bills. — Bills  of  exchange  may  be  classified  in 
three  different  ways: 

1.  As  to  their  maturity. 

2.  As  to  whether  or  not  they  bear  accompanying  documents 

to  serve  as  collateral  security. 

3.  As  to  their  uses. 

Bills  drawn  at  sight  or  on  demand  are  payable  immediately 
upon  presentation  to  the  drawee  and  are  known  as  "sight"  bills 
or  "demand"  bills.  When  bills  are  so  drawn  it  is  evident  that 
there  is  no  occasion  for  acceptance  by  the  drawee,  for  the  reason 
that  if  the  drawee  is  willing  to  treat  a  sight  bill  as  his  obligation 
it  is  his  duty  to  make  payment  at  once.  By  payment  he  takes 
immediate  possession  of  it  and  consequently  there  is  no  purpose 
served  in  writing  "Accepted"  upon  it.  There  are  one  or  two 
exceptions  to  this  statement.  The  certification  of  a  check  by  a 
drawee  bank  constitutes  an  acceptance  of  a  demand  draft  and 
thus  gives  the  holder  of  it  a  special  security;  and  sight  sterling 
drafts  drawn  on  British  importers  and  payable  at  a  bank  are 
first  presented  to  drawees  for  acceptance. 

Time  bills  may  be  drawn  payable  a  specified  number  of  days 


38  BANKING  AND  CREDIT  [  III 

after  date  or  after  sight  or  demand.  In  the  latter  case  the  time  of 
acceptance  is  the  date  of  sight  or  demand,  from  which  the  date  of 
maturity  is  determined,  and  therefore  immediate  presentment  for 
acceptance  is  necessary  in  order  to  insure  the  maturity  of  the 
instrument  at  as  early  a  date  as  possible.  Bills  that  are  drawn 
payable  at  30  days  and  under  are  called  "  short "  bills,  while  those 
that  run  for  a  longer  period  are  known  as  "long"  bills. 

With  respect  to  the  second  classification,  bills  bearing  accom- 
panying documents  to  serve  as  collateral  security  are  known  as 
"documentary"  bills,  while  those  with  no  documents  attached 
are  called  "  clean  "  bills.  Such  documents  include  bills  of  lading, 
insurance  policies  or  certificates,  and  commercial  invoices.  In 
the  case  of  foreign  drafts  they  may  also  include  consular  invoices, 
certificates  of  origin,  certificates  of  inspection,  and  similar  papers, 
according  to  the  character  and  destination  of  the  shipment. 

5.  The  Uses  of  Bills  of  Exchange— Commercial. — Finally 
with  reference  to  their  uses,  bills  of  exchange  may  be  drawn  to 
make  immediate  transference  of  bank  funds  from  one  person  to 
another  or  to  withdraw  such  funds,  as  in  the  use  of  a  check;  to 
facilitate  the  purchase  of  some  commodity  either  by  a  bank 
acceptance  when  the  bank  is  acceptor  or  by  a  trade  acceptance 
when  the  debtor  is  the  acceptor;  to  enable  banks  to  raise  funds 
by  issuing  "finance"  bills;  or  to  provide  a  means  whereby  a 
creditor  can  bring  pressure  upon  a  slow  debtor  to  discharge  his 
obligations. 

The  ordinary  trade  acceptance  (Form  2)  is  created  when,  for 
example,  the  seller  of  merchandise  draws  a  draft  on  the  pur- 
chaser for  the  amount  of  the  invoice  and  the  purchaser  accepts 
the  draft.  The  purchaser,  however,  may  make  arrangements 
with  his  bank  whereby  the  bill  is  drawn  on  the  bank  and  is  ac- 
cepted by  it  for  his  account  instead  of  by  the  purchaser  himself. 
When  accepted,  such  a  bill  becomes  a  bank  acceptance  (Form  3). 
The  Federal  Reserve  Board  has  defined  a  bank  acceptance  as  "a 


Ill  ]  COMMERCIAL  CREDIT  INSTRUMENTS  39 

draft  or  bill  of  exchange  of  which  the  acceptor  is  a  bank  or  trust 
company,  or  a  firm,  person,  company  or  corporation  engaged  in 
the  business  of  granting  bankers'  acceptance  credits." 

Bank  acceptances  are  used  to  a  large  extent  in  financing 
foreign  trade  and  domestic  transactions  involving  not  only  the 


No.  56g  Boston,  Mass.,  September  25,  192/  $14,150.63 

Ninety  days...    after  sight  pay  to  order  of    ...Ourselves   Fourteen 
thousand  one  hufidred  fifty  and  6j/ioo .  . .   Dollars. 

The  obligation  of  the  acceptor  hereof  arises  out  of  the  purchase  of 
goods  from  the  drawer. 

To  R.  A.  Powers  &  Company 

Boston,  Mass.  II.  C.  Jackson 


Form  2.     Trade  Acceptance 

more  important  staple  commodities  but  also  many  other  kinds  of 
merchandise,  such  as  automobile  tires  of  special  make.  Bank 
acceptances  offer  a  means  of  investment  in  which  the  credit  risk 


No.  1^0  Yokohama,  Japan,  January  10,  1927 

Ninety  days...   after  sight  pay   to  the  order  of  ..  .Ourselves  Eighty- 
five    thousand     and     two     hundred. .  .      Dollars $85,200.00 

Drawn  under   .  .  .Eighth  National  Bank  Letter  of  Credit  T^J^Jf^/  dated 
December  16,  191 9 
Value  received  and  charge  the  same  to  the  account  of 
To  Eighth  National  Bank 

Boston,  Mass.  O.  Y.  Kioto  &  Company 


Form  3.     Bank  Acceptance 

is  practically  eliminated,  for  the  reason  that  direct  responsibility 
for  their  payment  rests  on  banking  institutions  whose  credit  is 
generally  well  known.  For  a  long  period  acceptances  have  occu- 
pied a  very  important  position  in  the  foreign  commerce  of  all 


40  BANKING  AND  CREDIT  [  HI 

countries,  including  the  United  States.  However,  in  the  domestic 
commerce  of  the  United  States  acceptances  during  the  past  half- 
century  have  not  played  any  large  part,  as  they  have  in  Europe. 
Under  the  administration  of  the  federal  reserve  system  an  effort 
is  being  made  to  give  them  a  wider  use. 

6.  Finance  Bill.— The  term  "finance  bill"  is  comparatively 
recent  and  designates  long  drafts  drawn  by  bankers  or  stock 
exchange  houses  upon  foreign  banking  or  accepting  houses  for  the 
purpose  of  raising  funds  in  the  country  in  which  they  are  drawn. 
The  effect  of  drawing  finance  bills  is  to  utilize  the  foreign  money 
market  in  financing  some  domestic  undertaking.  For  example, 
suppose  that  the  Atlas  National  Bank  of  New  York  has  arranged 
with  a  London  bank,  by  pledging  securities  at  an  acceptable  New 
York  depository  (although  the  credit  may  have  been  extended 
without  collateral  requirements)  for  the  drawing  of  a  90  days' 
sight  bill  on  London.  The  New  York  bank  is  now  in  a  position 
either  to  sell  in  the  local  market  a  90  days'  sight  bill  for  the  face 
of  the  credit  or  to  forward  the  90  days'  sight  bill  to  London  with 
instructions  that  the  draft  be  discounted  and  the  proceeds  be 
placed  to  its  credit.  Against  this  credit  the  New  York  bank  may 
sell  a  demand  draft.  Which  of  the  two  plans  the  New  York  bank 
will  follow  depends  upon  the  exchange  rates  on  London  existing 
at  that  time.  In  either  case,  however,  neither  the  New  York 
bank  nor  its  London  correspondent  will  have  to  put  up  any  funds 
at  the  start.  The  London  discount  market  provides  the  funds 
until  the  maturity  of  the  draft,  when  the  London  correspondent 
looks  to  the  New  York  bank  for  the  necessary  cover  to  meet  the 
draft  plus  a  small  commission. 

Finance  bills  are  commonly  drawn  for  three  purposes:  (i)  to 
take  advantage  of  the  situation  when  interest  rates  are  higher  at 
home  than  abroad;  (2)  to  anticipate  an  expected  fall  in  foreign 
exchange  rates;  or  (3)  to  raise  funds  regardless  of  interest  or  ex- 
change rates. 


Ill  1  COMMERCIAL  CREDIT  INSTRUMENTS  4I 

7.  Dunning  Medium. — By  no  means  uncommon  in  domestic 
transactions  is  the  use  of  a  draft  for  dunning  a  slow  debtor  who 
persistently  refuses  payment  of  an  overdue  account.  The  credi- 
tor by  drawing  a  bill  upon  the  debtor  forces  the  latter  either  to 
pay  or  to  disclose  his  refusal  to  some  local  bank  to  which  the  draft 
has  been  given  for  collection  and  with  which  the  debtor  may  very 
likely  wish  to  maintain  his  credit  standing. 

8.  Checks. — A  check  is  a  written  order  for  money,  payable 
on  demand,  and  drawn  on  a  bank  by  a  depositor,  its  cashier,  or 
another  bank.  It  does  not  have  to  be  in  any  prescribed  form, 
though  in  modern  practice  there  is  a  uniform  style.  A  common 
type  is  shown  in  Form  4.     The  drawer,  or  maker,  is  D.  E.  Fisher; 


No.  4g  Boston,  April  5,  1922 

HUB   NATIONAL  BANK 

Pay  to  the  order  of   . .  .A.  B.  Curtis $4r(h> ■  ■  ■ 

Four  ro-o Dollars 

D.  E.  Fisher 


Form  4.     Bank  Check 

the  drawee  is  the  Hub  National  Bank;  the  payee  is  A.  B.  Curtis. 
The  bank  or  drawee  will  not  honor  or  make  payment  on  this 
check,  except  at  its  peril,  until  the  check  has  been  indorsed  by  the 
payee. 

During  the  latter  part  of  the  seventeenth  century  merchants 
in  England  frequently  deposited  their  money  for  safe-keeping 
with  goldsmiths  who  had  special  facilities  for  taking  care  of  valu- 
ables. It  then  became  a  practice  for  merchants  to  issue  orders 
upon  the  goldsmiths  when  desiring  to  make  payment;  and  the 
issue  of  these  demands  or  orders  marks  the  origin  of  the  check 
system  in  England.  One  of  these  old  checks  drawn  on  a  gold- 
smith, issued  in  1675,  reads  as  follows: 


42  BANKING  AND  CREDIT  [III 

Mr.  Thomas  ffowles. 

I  desire  to  pay  unto  Mr.  Samuell  Howard  or  order  upon  receipt  hereof 

the  sume  of  nine  pounds  thirteene  shillings  and  sixe  pence  and  place 

it  to  the  account  of 

Yr  servant, 

Edmond  Warcupp 
14  Augt.,  1675 

£9  =  13  =  6 
For  Mr.  Thomas  ffowles,   Gouldsmith,  at  his  shop  betweene   the   two 
Temple  gates,  Fleetestreete. 

On  the  back: 

Reed  in  full  of  this  bill  the  sume  of  nine  pounds  thirteen  shillings  sixpence. 

Saml.  Howard 

Private  bankers  extended  the  practice  until  by  1 780  it  became 
general.  London  banks  other  than  the  Bank  of  England  then 
began  to  discontinue  their  note  issue.  Instead  of  receiving  a  roll 
of  notes  the  bank's  customer  obtained  a  book  of  order  forms  pay- 
able to  bearer  on  demand  and  the  bank  undertook  to  honor  such 
orders  so  long  as  it  had  assets  of  the  drawer  on  hand.  These 
order  forms  were  issued  payable  to  bearer  and  on  demand  in 
imitation  of  the  notes  which  they  were  intended  to  replace.  Just 
as  the  promissory  notes  bore  registered  serial  numbers  for  ready 
verification,  when  the  note  was  presented  for  payment,  so  these 
books  of  forms  were  similarly  numbered.  The  practice  of  placing 
serial  numbers  upon  these  instruments  as  a  check  or  means  of 
identification  is  the  explanation  offered  by  some  writers  as  to  the 
derivation  of  the  modern  word  " check." ^ 

9.  Drawing  of  Checks. — In  writing  a  check  good  practice 
demands  that  it  be  dated,  but  this  is  not  legally  necessary;  its 
validity  and  negotiability  are  not  affected  by  the  fact  that  it 
bears  no  date.     If  the  instrument  is  not  dated  the  holder  has 


F.  Tillyard,  Banking  and  Negotiable  Instruments,  p.  3. 


Ill]  COMMERCIAL  CREDIT  INSTRUMENTS  43 

prima  facie  authority  to  till  in  the  date.  It  can  be  dated  on  a 
Sunday,  as  it  is  not  in  itself  a  contract.  The  date  is  usually  that 
of  its  issuance,  although  legally  it  may  be  dated  back  or  dated 
ahead.  However,  a  check  is  not  payable  before  its  date.  Checks 
are  frequently  postdated,  especially  by  those  whose  deposit  is 
insufi&cient  to  pay  the  check  at  the  time  of  its  delivery.  Post- 
dated checks  of  this  kind  have  often  been  held  to  be  valid  by  the 
courts,  provided  the  postdating  is  not  done  for  a  fraudulent  pur- 
pose.^ 

To  be  negotiable,  checks  must  be  made  payable  "to  bearer" 
or  "to  the  order  of."  In  drawing  a  check  to  oneself  it  is  better 
practice  to  make  it  payable  to  the  order  of  "cash"  than  to  make 
it  payable  to  "bearer."  In  either  case  it  is  the  custom  of  banks  to 
insist  that  the  check  be  indorsed  by  the  payee  but  not  by  the 
maker.  It  is  probable,  however,  that  the  bank  does  not  have  the 
legal  right  to  insist  upon  indorsement,  provided  the  person  pre- 
senting the  check  is  satisfactorily  identified. 

Where  the  sum  payable  is  expressed  in  words  and  also  in 
figures,  and  there  is  discrepancy  between  the  two,  the  sum  de- 
noted by  the  words  is  the  sum  payable;  but  if  the  words  are  am- 
biguous or  uncertain, reference  may  be  had  to  the  figures  to  fix  the 
amount.^ 

10.  Presentation  of  Checks. — A  check  should  be  promptly 
presented.  If  it  is  not,  a  drawer  may  be  discharged  from  liability 
to  the  extent  of  the  loss  caused  by  the  delay.  If,  for  example,  the 
bank  failed  after  there  had  been  opportunity  for  presentation 
of  the  check,  the  payee  would  lose  and  could  not  recover  from  the 
drawer.  A  local  check  should  be  presented  before  the  close 
of  banking  hours  on  the  next  business  day  following  the  date  of 
issue.  In  order  to  charge  the  drawer  of  a  check  with  liability, 
the  check  must  be  presented  for  payment  within  a  reasonable 


=  J.  E.  Brady,  The  Law  of  Bank  Checks,  p.  23. 
3  Uniform  Negotiable  Instruments  Law. 


44  BANKING  AND  CREDIT  [III 

time  after  its  issue,  and  in  determining  what  is  a  reasonable  time 
there  must  be  taken  into  account  the  nature  of  the  instrument, 
the  usage  of  trade  or  business,  and  the  facts  of  the  particular  case. 
If  the  check  bears  a  date  considerably  previous  to  the  time  of 
presentation  it  is  known  as  a  "stale"  check  and  probably  will  be 
carefully  scrutinized.  How  long  before  a  check  is  considered  stale 
is  not  a  definite  and  fixed  matter.  A  check  a  month  old  has  been 
decided  not  to  be  stale,  but  one  5  months  old  has  been  so  treated. 
The  teller  must  decide  this  question  after  a  consideration  of  all 
the  facts. 

An  indirect  routing  of  a  check  is  liable  to  result  in  a  loss  to  the 
owner  thereof.  This  is  illustrated  by  a  case  which  arose  in  Ala- 
bama. A  check  drawn  on  a  bank  located  at  Greenville,  Alabama, 
was  received  by  the  payee  in  Philadelphia  on  December  12  after 
banking  hours  and  deposited  the  next  day  in  a  local  bank  for 
collection.  This  bank,  instead  of  sending  the  check  directly  to  a 
person  or  bank  at  the  place  where  the  drawee  bank  was  located, 
which  would  have  made  it  possible  to  present  the  check  on  or 
before  December  17,  sent  the  check  to  a  bank  in  South  Carolina, 
which  forwarded  it  to  another  bank  in  Montgomery,  Alabama, 
by  which  it  was  sent  to  a  person  in  Greenville,  Alabama,  by  whom 
it  was  presented  to  the  drawee  on  December  10,  one  day  after  the 
drawee  had  failed.  There  was  no  proof  to  show  that  the  manner 
of  collection  adopted  by  the  Philadelphia  bank  was  based  upon 
custom,  or  any  previous  dealings  between  the  parties.  In  an 
action  by  the  payee  of  the  check  against  the  drawer,  to  recover 
the  price  of  the  goods  for  which  the  check  was  given,  judgment 
was  given  for  the  defendant,  because  of  the  undue  delay  in  pre- 
sentment.'' 

1 1 .  Responsibility  of  Drawee  Bank. — The  drawer  of  the  check 
is  responsible  for  carelessness  in  making  the  check.  Legally  it 
may  be  written  with  pencil,  but  this  leads  to  errors  and  fraud. 
In  writing  the  sum  it  is  customary  to  begin  at  the  left-hand 
margin  in  order  to  lessen  opportunity  for  raising  the  amount.    A 


•»  J.  E.  Brady,  The  Law  of  Bank  Checks,  p.  102 


II f  ]  COMMERCIAL  CREDIT  INSTRUMENTS  45 

bank  in  paying  a  forged  check  is  responsible,  for  it  is  assumed  to 
be  familiar  with  signatures  of  depositors.  If  a  check  which  has 
been  properly  made  out  is  raised  and  then  cashed,  the  loss  may 
fall  upon  the  bank.  If,  however,  the  drawer  of  a  check  leaves  a 
blank  which  admits  of  opportunity  for  alteration,  he  may  be  held 
negligent. 

A  holder  (payee)  of  a  check  has  no  legal  rights  upon  the  bank 
upon  which  it  is  drawn,  although  the  drawer  has  funds  on  deposit. 
The  drawer  can  claim  payment,  but  not  the  payee.  If  the  check 
is  not  paid,  the  payee  can  sue  the  drawer. ^  Although  the  payee 
cannot  compel  the  bank  to  honor  the  check,  the  bank  is  under 
obligation  to  the  depositor  to  protect  his  reputation.  A  refusal 
to  pay  a  check  properly  drawn  and  presented,  if  there  be  suihcient 
funds  on  deposit,  would  injure  the  depositor's  credit  and  give 
cause  for  action  against  the  bank.  A  bank,  however,  is  under  no 
obligation  to  make  a  partial  payment  up  to  the  amount  which 
may  be  on  deposit,  when  the  check  is  in  excess. 

12.  Certified  Check. — A  certified  check  is  a  check  which  has 
written  upon  it  an  acknowledgment  by  the  bank  that  the  drawer 
of  the  check  has  sufficient  funds  on  deposit  to  pay  it.  It  is  prac- 
tically equivalent  to  a  bank  note  so  far  as  the  issuing  bank  is 
concerned.  The  acknowledgment  is  made  by  writing  across  the 
face  of  the  check  the  word  "  Good, "  "Accepted, "  or  "Certified, " 
and  the  name  of  the  bank  official  assigned  by  the  bank  for  this 
duty.  Certified  checks  are  commonly  used  by  persons  when  their 
ordinary  personal  checks  would  not  be  readily  accepted.  In 
most  banks  the  cashier  generally  certifies  checks.  Some  banks 
prefer  not  to  certify  checks  but  to  take  up  the  check  and  issue  a 
cashier's  check  against  it,  inasmuch  as  there  is  less  opportunity 
for  a  banker's  check  to  be  subsequently  tampered  with  if  it  should 
fall  into  the  hands  of  a  fraudulent  person. 


s  In  a  few  states  the  payee  may  bring  action  against  the  bank  on  the  theory  that  draw- 
ing a  check  is  an  assignment  to  a  payee. 


46  BANKING  AND  CREDIT  [  III 

Certification  constitutes  a  contract  between  the  holder  and  the 
bank;  the  amount  of  the  check  is  set  apart  out  of  the  drawer's 
deposit  for  the  purpose  of  paying  the  check.  In  legal  contem- 
plation and  effect  a  certified  check  is  thus  a  certificate  of  deposit 
issued  by  the  certifying  bank. 

13.  Cashier's  Check. — A  cashier's  check  is  a  check  drawn  by  a 
bank  against  itself,  and  usually  signed  by  its  cashier,  payable 
when  presented  at  the  bank  drawing  the  same.  Such  a  check  is 
commonly  used  by  a  person  whose  own  check  would  not  be  so 
readily  accepted  as  the  check  of  some  known  bank.  A  cashier's 
check  may  be  used  by  a  person  not  having  a  bank  account  and 
therefore  unable  to  draw  a  check  of  his  own.  A  slight  charge 
may  be  made  for  the  accommodation. 

14.  Stop  Payment  of  Check. — A  notice  to  stop  payment  of  a 
check,  to  be  effective,  must,  of  course,  be  received  by  the  bank 
before  the  check  has  been  presented  or  certified.  It  is  not  unusual 
for  a  bank  to  require  that  stop  orders  be  written.  A  telegram 
directing  that  the  payment  of  a  check  be  stopped  may  be  acted 
upon  by  a  bank  at  least  to  the  extent  of  delaying  the  payment 
until  further  inquiry  can  be  made.  However,  a  bank  is  not  legally 
bound  to  accept  an  unauthenticated  telegram  as  a  requirement  for 
refusing  payment. 

15.  Promissory  Notes. — Whereas  a  bill  of  exchange  is  an 
order,  a  promissory  note  is  a  promise  to  pay  money  on  the  part 
of  the  one  who  writes  it.  A  promissory  note  is  an  unconditional 
promise  in  writing  made  by  one  person  to  another,  signed  by  the 
maker,  engaging  to  pay  on  demand,  or  at  a  fixed  or  determinable 
future  time  a  sum  certain  in  money  to  order  or  to  bearer. 

To  the  note  as  shown  in  Form  5,  there  may  or  may  not  be 
added  an  interest  clause  such  as  "With  interest  at  6  per  cent  per 
annum."    Occasionally  promissory  notes  bear  an  interest  clause 


Ill]  COMMERCIAL  CREDIT  INSTRUMENTS  47 

in  which  the  rate  is  not  specified,  the  rate  implied  being  the  legal 
rate  of  interest  in  the  state  of  the  promisor.    In  the  absence  of  an 


$750.00  Boston,  Alass.,  July  10,  192/ 

Sixty  days after  date, / promise  to  pay  to  the  order 

of A.B.  Curtis $750 

Value  received.  D.  E.  Foster 


Form  5.     Promissory  Note 

interest  clause  the  full  sum  due  upon  the  above  note  at  its  matur- 
ity is  $750.  When  a  note  is  drawn  to  the  maker's  own  order  it  is 
not  complete  until  indorsed  by  him. 

If  A.  B.  Curtis  wishes  to  sell  this  note  before  maturity  he 
indorses  it  by  writing  his  name  across  the  back.  This  act  trans- 
fers the  right  to  receive  payment ;  it  also  adds  the  implied  promise 
that  the  indorser  will  pay  the  note  if  the  maker  refuses.  If  the 
indorsement  is  made  in  blank,  that  is,  by  writing  simply  the  name 
(without  ''pay  to  the  order  of"),  the  note  can  be  transferred 
from  one  person  to  another  without  further  indorsement.  Each 
additional  indorsement,  however,  adds  to  the  security.  If  the 
holder  of  a  note  wishes  to  transfer  or  assign  it  with  distinct  dis- 
avowal of  responsibility,  and  this  is  satisfactory  to  the  person 
receiving  it,  he  may  add  to  his  indorsement  the  words,  "Without 
recourse." 

The  order  of  liability  on  a  promissory  note  is:  (i)  drawer  or 
maker,  (2)  first  indorser,  (3)  second  indorser,  etc.^  An  indorser 
can  collect,  if  possible,  from  those  who  indorsed  above  him,  but 
not  from  those  below.  The  holder  of  the  note  can  proceed  against 
any  one  or  all  of  the  indorsers. 

16.  Single-  and  Double-Name  Paper. — If  a  note  bears  simply 
the  name  of  the  maker  for  its  security  it  is  called  "single-name" 

^  With  respect  to  one  another,  indorsers  are  liable  prima  facie  in  the  order  in  which  they 
indorse,  but  evidence  is  admissible  to  show  that  they  may  have  agreed  otherwise. 


48  BANKING  AND  CREDIT  [III 

paper;  if  indorsed  by  another  it  is  "  two-name  "  paper.  A  manu- 
facturer, for  example,  wishing  to  obtain  the  use  of  $5,000  may 
give  his  own  note  to  a  bank  and  on  that  personal  security  borrow 
funds.  The  note  thus  given  is  single-name  paper.  Or  he  might 
take  the  note  of  a  jobber  to  whom  he  had  sold  goods  for  $5,000, 
indorse  it,  and  obtain  funds  from  a  bank.  This  note  then  be- 
comes two-name  paper.  A  considerable  portion  of  the  paper  dis- 
counted by  banks  in  the  United  States  is  double-name  paper,  and 
some  hold  that  this  paper  is  safest,  partly  because  it  bears  two 
names,  and  partly  because  it  arises,  presumably,  from  an  actual 
commercial  transaction  in  which  there  has  been  a  sale  of  goods 
and  consequently  clear  evidence  of  value  behind  the  note  which 
ultimately  will  liquidate  the  obligation.  On  the  other  hand 
the  note  of  a  strong  business  house  reputed  to  be  solvent  is  often 
as  acceptable  to  a  bank,  even  if  there  be  no  immediate  evidence 
in  the  making  of  the  note  that  a  particular  sale  has  been  made. 

The  specimen  note  shown  in  Form  5  might  have  originated 
in  the  sale  of  $750  worth  of  goods  by  Curtis  to  Foster  on  60  days' 
time.  The  chief  advantage  to  Curtis  pf  the  note,  as  distinguished 
from  a  book  account  charge  against  Foster,  is  its  superiority  as  a 
means  of  obtaining  cash  immediately.  Curtis  may  sell  the  note 
to  his  bank  for  perhaps  $742. 50  ($750  discounted  at  6  per  cent),  or 
he  may  pledge  it  for  a  direct  loan  against  his  own  note. 

A  second  and  more  important  source  of  short-time  promissory 
notes  is  the  straight  loan,  by  which  is  meant  a  direct  advance  of 
money,  or  the  right  to  draw  money,  based  upon  a  promise  that 
the  sum  will  be  returned  with  interest  in  the  future.  A  high  per- 
centage of  the  direct  short-term  loans  in  this  country  are  made  by 
banks  to  their  clients  in  all  lines  of  business.  Discussion  of  the 
subject  of  loans  and  incidental  points  is  reserved  for  another 
chapter. 

17.  Accommodation  Paper. — Accommodation  paper  is  a  bill 
of  exchange  or  a  promissory  note  to  which  the  acceptor,  maker. 


Ill  1  COMMERCIAL  CREDIT  INSTRUMENTS  49 

drawer,  or  indorser  has  signed  his  name,  without  receiving  value, 
for  the  purpose  of  obliging  by  the  loan  of  his  credit  some  other 
person  who  is  to  pay  the  note  or  bill  at  maturity.  Any  individual 
who  lends  his  name  to  commercial  paper  is,  of  course,  held  for  its 
payment,  no  matter  what  may  be  his  intention  in  the  beginning 
or  his  private  understanding  with  the  accommodated  person. 
Accommodation  paper  is  looked  upon  by  banks  with  more  or  less 
suspicion.  There  is  no  value  received  and  it  is  not  self-liquidating 
in  the  sense  of  being  based  on  a  merchandise  transaction. 

18.  Money-Orders. — Money-orders  are  issued  by  post-ofifices, 
express  companies,  telegraph  companies,  and  banks,  and  are 
used  for  remitting  funds  of  small  amounts.  A  postal  money- 
order  is  a  government  order  issued  at  one  office  and  payable  at 
another.  The  maximum  amount  for  which  a  single  postal  order 
may  be  issued  in  the  United  States  is  $100.  When  a  larger  sum 
is  to  be  sent,  additional  orders  must  be  obtained.  International 
money-orders  make  it  possible  for  sums,  usually  not  exceeding 
$100,  to  be  remitted  cheaply  to  the  principal  countries  of  the 
world.  The  fees  charged  by  the  different  issuing  agencies  are 
substantially  the  same.  For  postal  money-orders  the  rates  range 
from  3  cents,  when  the  amount  is  $2.50  or  less,  to  30  cents  for 
$100. 

A  bank  money-order  is  an  order  for  the  payment  of  money 
issued  by  a  bank  and  payable  at  certain  other  designated  banks 
in  different  parts  of  the  country.  The  fees  charged  for  bank 
money-orders  are  approximately  the  same  as  for  postal  and 
express  money-orders.  Bankers'  limited  checks  are  used  com- 
monly for  remitting  small  sums  of  money  to  any  part  of  the 
world.  Indicated  on  the  face  are  certain  fixed  limits  in  various 
currencies.  For  amounts  in  excess  of  the  sums  stated  it  is  cheaper 
and  more  convenient  to  purchase  drafts.  The  bank  postal  re- 
mittance system  is  considered  in  a  subsequent  section. 

Telegraphic  money-orders  are  telegrams  of  telegraph  or  ex- 


50  BANKING  AND  CREDIT  [III 

press  companies  ordering  the  payment  of  money  at  some  other 
designated  place.  Remittance  of  funds  by  telegraph  is  common 
in  foreign  trade,  and  foreign  exchange  markets  have  daily  quota- 
tions giving  the  telegraphic  or  cable  transfer  rates  on  the  principal 
commercial  centers  of  the  world. 

The  remittance  of  funds  by  money-order  is  mostly  a  matter  of 
bookkeeping  on  the  part  of  the  agency  issuing  the  order.  No 
money  is  transferred  from  one  place  to  another;  a  certain  sum  is 
received  at  one  place  and  an  equivalent  sum  paid  at  another 
place. 

19.  Bank  Postal  Remittance. — The  term  "bank postal  remit- 
tance" refers  to  a  special  class  of  transactions  utilized  chiefly  to 
meet  the  requirements  of  European  immigrants  to  the  United 
States,  who  wish  to  send  money  to  the  old  country,  and  to  facili- 
tate the  transfer  of  funds  to  places  where  banking  facilities  are 
somewhat  limited.  The  class  of  persons  to  whom  immigrants 
usually  send  money  would  experience  inconvenience  in  getting 
an  ordinary  banker's  check  or  draft  cashed. 

The  postal  remittance  system  may  be  compared  to  the  money- 
order  system  in  this  country.  The  American  bank,  in  return  for 
dollars  received  from  the  remitter,  notifies  its  foreign  correspon- 
dent bank  to  pay  the  equivalent  in  the  local  currency,  as  deter- 
mined by  the  rate  of  exchange  prevailing  when  the  order  is  taken, 
to  a  specified  person  in  that  country.  The  foreign  bank  then 
either  buys  a  postal  money-order  or  puts  the  actual  currency  in 
an  envelope  and  sends  it  to  the  beneficiary  through  the  mails. 
The  foreign  bank  charges  the  remitting  bank's  account  and 
usually  deducts  its  own  charges,  if  any,  from  the  face  amount  of 
the  remittance. 

Banks  in  this  country  which  do  not  carry  accounts  abroad 
invariably  sell  foreign  checks  and  postal  remittances  under  the 
protection  of  the  large  New  York  banks  which  maintain  connec- 
tions throughout  the  world.    When  the  purchaser  pays  for  the 


Ill  J  COMMERCIAL  CREDIT  INSTRUMENTS  5 1 

postal  remittance  he  is  given  a  receipt  to  be  retained  by  himself 
and  also  a  memorandum,  containing  explanations  in  about  a 
dozen  languages,  which  he  is  to  mail  to  the  person  who  is  to  re- 
ceive the  money.  This  memorandum  is  in  no  way  a  draft  or  order 
but  is  simply  a  statement  of  advice,  the  order  to  pay  having  been 
forwarded  by  the  bank  direct  to  its  correspondent  abroad. 

20.  Circular  Notes. — Circular  notes  (often  written  in  French) 
are  sometimes  issued  by  banks  and  tourist  agencies.  They  are 
similar  to  travelers'  checks  in  form  and  use,  and  are  issued  for 
round  sums  of  a  given  currency  (dollars,  francs,  pounds  sterling, 
etc.) .  They  are  payable  at  the  amount  for  which  they  are  issued, 
without  deduction  in  the  countries  which  use  that  currency.  In 
places  where  the  local  money  differs  from  that  specified  on  the 
circular  notes,  the  equivalent  of  the  amount  is  paid  at  the  ex- 
change rate  when  cashed.  At  present  (1922)  there  is  very  little 
difference  between  a  circular  note  and  a  travelers'  check,  because 
banks, on  account  of  the  unsettled  conditions  of  foreign  exchanges, 
have  generally  ceased  the  practice  of  issuing  travelers'  checks 
payable  at  fixed  rates  in  foreign  currencies. 

21.  Travelers'  Checks. — A  travelers'  check  (Form  6)  is  in 
effect  a  circular  note  made  out  by  a  bank,  express  company,  or 
tourist  agency  to  the  order  of  the  traveler  as  payee.  For  con- 
venience they  are  made  out  in  small  sums  and  are  available  not 
only  for  foreign  but  for  domestic  travel.  The  checks  are  for  rela- 
tively small  amounts  and  are  generally  accepted  by  railroad 
companies,  large  stores,  tourist  agencies,  and  hotels  without 
imposing  on  the  traveler  the  burden  of  cashing  them  at  a  bank. 
They  are  issued  in  series  or  packages  in  varied  denominations, 
generally  from  Sio  to  $200,  each  bearing  the  signature  of  the 
bearer  written  in  at  the  time  of  purchase  and  each  being  counter- 
signed by  the  bearer  when  presented  for  payment .  Until  recently 
on  each  check  there  was  indicated  opposite  its  value  in  United 


52 


BANKING  AND  CREDIT 


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States  money  the  cash  equivalent  in  English,  French,  Italian. 
German,  or  other  foreign  money.  Thus  if  the  traveler  were  in 
Italy  and  had  a  $20  check  he  would  know  without  asking  that  it 
was  worth  102  lire  and  50  centesimos.  At  present  (1922)  Ameri- 
can banks  are  issuing  travelers'  checks  payable  not  in  fixed  equiv- 
alents of  foreign  currency  but  at  the  rate  at  the  time  of  encash- 
ment for  sight  drafts  on  New  York.  While  the  original  plan  for 
making  payments  was  satisfactory  under  normal  conditions,  the 
disorganization  of  the  foreign  exchanges  brought  about  by  the 
war  has  rendered  it  in  most  cases  unsuitablq  for  the  needs  of  the 
traveler  today. 

Travelers'  checks  generally  offer  a  much  more  satisfactory 
means  of  carrying  funds  than  do  drafts.  The  latter  must  be 
cashed  in  a  single  lump  sum  which  may  be  somewhat  larger  than 
the  traveler  wishes  to  carry  on  his  person,  and  which  may  be  a 
decided  disadvantage  if  a  little  later  a  journey  is  made  into 
another  country  where  a  different  currency  is  in  use.  Under  the 
standard  terms  in  the  United  States  these  checks  are  sold  for  their 
face  value  in  dollars  plus  a  commission  of  3/4  per  cent,  or  75 
cents  per  $100  worth,  with  a  minimum  commission  of  75  cents. 

22.  Certificates  of  Deposit. — By  depositing  a  sum  of  money 
in  a  bank  a  person  may,  if  he  wishes,  receive  a  certificate  of  de- 
posit instead  of  a  credit  to  a  regular  checking  account.  A  certifi- 
cate of  deposit  is  both  a  receipt  and  a  promissory  note  and  may 
be  drawn  payable  to  any  person  whom  the  depositor  may  name. 
The  certificate  may  be  either  negotiable  or  non-negotiable  and 
may  be  made  payable  on  demand  or  after  a  definite  time.  The 
demand  certificate  is  used  principally  for  the  purpose  of  guaran- 
teeing payment  to  a  creditor  and  also  as  an  old  method  followed 
by  some  banks  in  transferring  cash  to  distant  points.  In  many 
respects  a  demand  certificate  is  similar  to  a  certified  check  or  a 
bank  draft. 

The  time  certificate  usually  yields  a  fair  rate  of  interest  and 


54  BANKING  AND  CREDIT  [III 

offers  the  depositor  a  return  on  any  temporary  idle  money  that 
he  is  wilHng  to  turn  over  to  the  bank.  For  example,  suppose  Mr. 
A  has  $10,500  to  lend  for  6  months.  He  can  buy  commercial 
paper,  a  corporate  short-term  note,  etc.,  of  that  maturity.  But 
he  cannot  judge  the  soundness  of  these  investments.  He  goes, 
therefore,  to  a  bank  (any  large  bank)  and  buys  (for  that  is  what 
the  transaction  virtually  amounts  to)  a  6  months'  certificate 
(Form  7)  yielding,  to  be  sure,  a  lower  rate  than  the  investments 
alluded  to  above  would.    The  bank  prefers  to  issue  the  certificate 


$10,500  Boston,  Mass.,  ...Mar.  15,  1922  No.  1672 

EIGHTH   NATIONAL  BANK 

Cliarle.';     T.    Adams....    has    deposited     ....ten    tJwusand    and   five.... 

hundred Dollars 

Payable  to  the  order  of himself 

on  the  return  of  this  certificate  properly  indorsed   six 

months  after  date,   with   interest  at    4 per   cent   per   annum. 

George  F.  Tompkins 
Cashier. 


Fonn  7.     Certificate  of  Deposit 

rather  than  open  a  time  deposit  account,  simply  because  it  in- 
volves less  bookkeeping  and  other  clerical  work.  Mr.  A  is  to 
leave  the  funds  with  the  bank  only  for  6  months  and  the  bank 
therefore  does  not  consider  it  worth  while  to  enter  his  name  on 
the  deposit  ledger  and  go  through  the  formalities  incident  to  the 
opening  of  a  new  account. 

23.  Commercial  Paper. — "Commercial  paper"  is  a  term 
employed  more  or  less  loosely;  in  its  broadest  sense  it  includes  all 
forms  of  crecht  instruments  that  arise  from  business  operations. 
As  generally  used  in  the  money  market  it  may  be  defined  as 
promissory  notes  issued  by  business  concerns  for  the  purpose  of 


Ill  ]  COMMERCIAL  CREDIT  INSTRUMENTS  55 

carrying  on  commerce  and  sold  by  the  makers  in  the  open  market. 
This,  it  will  be  noted,  rather  rigidly  limits  the  character  of  the 
paper  included  in  the  category  to  strictly  direct  obligations  of  the 
makers.  Bankers'  acceptances  are  definitely  excluded,  and  trade 
acceptances  are  often  listed  either  separately  or  as  bills  receivable. 
Commercial  paper  is  sometimes  called  "purchased"  paper  as 
distinguished  from  discount  paper  of  the  bank's  own  customers. 

Commercial  paper,  as  defined  by  the  Federal  Reserve  Board 
regulations,  is  given  a  much  broader  interpretation  and  includes 
notes,  drafts,  and  bills  of  exchange,  which  arise  from  dealings  in 
merchandise  as  distinguished  from  loans  made  for  the  purpose 
of  trading  in  stocks  and  bonds.  Commercial  paper,  eligible  for 
rediscount  at  a  federal  reserve  bank,  must  be  a  note,  draft,  or 
bill  of  exchange  the  proceeds  of  which  have  been  used  or  are  to  be 
used  in  producing,  purchasing,  carrying,  or  marketing  goods 
(goods,  wares,  merchandise,  or  agricultural  products,  including 
livestock)  in  one  or  more  of  the  steps  of  the  process  of  production, 
manufacture,  or  distribution.  It  must  not  be  a  note,  draft,  or 
bill  of  exchange  the  proceeds  of  which  have  been  used  or  are  to  be 
used  for  permanent  or  fixed  investments  of  any  kind,  such  as 
land,  buildings,  or  machinery,  or  for  investments  of  a  purely  specu- 
lative character.  Notes  or  bills  with  the  proceeds  of  which  bonds 
and  notes  of  the  United  States  have  been  purchased  are  eligible. 

The  term  is  also  applied  without  any  qualifying  adjective  to 
promissory  notes  and  bills.  Paper  or  commercial  paper  is  further 
distinguished  as  agricultural  paper,  arising  from  the  sale  of 
agricultural  products,  and  mill  paper,  which  in  New  England 
refers  to  promissory  notes  and  bills  of  textile  mills.  Similarly 
in  the  Northwest,  notes  and  bills  secured  by  grain  held  in  eleva- 
tors are  known  as  "elevator"  paper.  Such  paper  is  also  called 
"trade"  paper. 

24.  Commodity  Paper. — Commodity  paper,  within  the  mean- 
ing of  the  Federal  Reserve  Act,  is  restricted  to  notes,  drafts,  bills 


56  BAxNKING  AND  CREDIT  |  III 

of  exchange,  or  trade  acceptances  accompanied  and  secured  by 
shipping  documents  or  by  a  warehouse,  terminal,  or  other  similar 
receipt  covering  approved  and  readily  marketable,  non-perish- 
able staples  properly  insured.  "Staples "  include  manufactured 
goods  as  well  as  raw  materials,  provided  the  goods  are  non-perish- 
able and  have  a  wide  market.  This  is  held  to  include  cotton 
yarns  and  flour.  Commodity  paper  comprises  not  only  paper 
originating  with  the  producer,  but  also  paper  of  merchants  and 
others  when  the  commodity  is  not  being  used  for  speculative  or 
purely  investment  purposes.  Potatoes,  properly  graded,  packed, 
and  stored  in  weather-proof  and  responsible  warehouses,  as  evi- 
denced by  its  receipt,  constitute  a  non-perishable  staple. 

25.  Volume  of  Credit  Instruments. — It  is  impossible  to  deter- 
mine the  total  amount  of  credit  instruments  outstanding  at  any 
one  time.  We  know  the  amount  of  coin  which  has  been  minted 
and  the  amount  of  government  and  bank  paper  money  which 
has  been  issued,  but  only  estimates  with  a  probable  wide  margin 
of  error  can  be  made  of  the  outstanding  volume  of  checks,  promis- 
sory notes,  bills  of  exchange,  and  the  other  miscellaneous  variety 
of  credit  instruments  which  society  has  devised.  Several  inves- 
tigations, however,  have  been  made  to  measure  the  proportionate 
use  of  credit  instruments  in  exchange  transactions  in  the  United 
States,  based  on  an  analysis  of  the  receipts  of  banking  institu- 
tions. For  example,  an  analysis  of  the  receipts  of  152  banks  lor 
six  consecutive  days  in  1871  showed  that  88  per  cent  was  in 
checks,  drafts,  and  commercial  bills.  Ten  years  later,  in  1881,  a 
similar  inquiry  based  on  the  receipts  of  over  2,000  banks  for  a 
single  day  gave  the  following  results : 

Per  Cent 

Checks,  drafts,  and  bills 91-85 

Clearing-house  certificates 2.24 

Paper  money 4.36 

Gold  coin 1.38 

Silver  coin .17 

100.00 


Ill]  COMMERCIAL  CREDIT  INSTRUMENTS  57 

The  returns  varied  for  different  parts  of  the  country.  In 
New  York  City  the  proportion  of  credit  instruments  ran  as  high 
as  98.7  per  cent,  while  in  some  of  the  states  it  was  as  low  as  65 
per  cent.  Subsequent  investigations  gave  substantially  the  same 
results.  The  last  and  most  exhaustive  inquiry  was  made  in  1909.  '^ 
It  was  then  concluded  ''that  a  large  proportion  of  the  business 
of  the  country,  even  the  retail  trade,  is  done  by  means  of  credit 
instruments.  While  it  is  probably  true  that  wage-earners,  as  a 
class,  do  not  commonly  use  checks,  it  is  also  true  that  a  great 
many  do.  Moreover,  the  use  of  checks  is  common  among  people 
who  derive  their  income  from  other  sources,  even  though  it  be 
not  larger  than  the  well-paid  laborer.  We  are  justified,  therefore, 
in  concluding  that  50  or  60  per  cent  of  the  retail  trade  of  the 
country  is  settled  in  this  way."^  Over  90  per  cent  of  the  whole- 
sale trade  of  the  country  is  done  with  checks  and  other  credit 
instruments;  of  weekly  pay-rolls  reported  by  the  banks  70  per  cent 
was  in  checks;  and  finally  "we  may  therefore  safely  accept  an 
average  of  80  to  85  per  cent  as  the  probable  percentage  of  business 
of  this  country  done  by  check." 

References 

Cleveland,  F.  A.     Funds  and  Their  Uses. 

Promissory  notes,  pp.  111-128;  checks,  pp.  55-66. 
Holdsworth,  J.  T.     Money  and  Banking,     pp.  114-116,  120-124. 
Moulton,  H.  G.     Financial  Organization  of  Society,     pp.  162-169. 

Principles  of  Money  and  Banking.     Part  II,  pp.  32-37. 

McMaster,  J.  S.     McMaster's  Irregular  and  Regular  Commercial  Paper. 
Contains  a  collection  of  forms  showing  notes,  checks,  drafts,  in- 
dorsements, etc.,  with  textual  explanation. 
Tillyard,  F.     Banking  and  Negotiable  Instruments. 

An  English  book  containing  in  the  appendix,  40  pages  of  forms  of 
checks,  bills  of  exchange,  letters  of  credit,  and  shipping  documents. 


7  Made  by  the  Comptroller  of  the  Currency  for  the  National  Monetary  Commission, 
under  the  editorial  supervision  of  David  Kinley. 

*  The  Use  of  Credit  Instruments  in  Payments  in  the  United  States,  by  David  Kinley 
(Report  of  National  Monetary  Commission),  p.  199. 


CHAPTER   IV 

COMMERCIAL  CREDIT  DOCUMENTS 

1.  Bills  of  Lading. — By  "commercial  credit  documents"  is 
here  meant  bills  of  lading,  warehouse  receipts,  trust  receipts,  and 
numerous  other  forms  which  serve  principally  as  evidences  of 
title  to  or  rights  in  goods.  It  is  the  purpose  of  this  chapter  to 
point  out  the  salient  features  of  the  more  important  of  these 
documents. 

A  bill  of  lading  is  a  document  containing  a  written  acknowl- 
edgment by  a  railroad,  steamship  company,  or  other  carrier, 
specifying  the  receipt  of  goods  for  transportation.  Besides  being 
the  final  receipt  from  the  carrier,  the  bill  of  lading  is,  in  effect,  a 
contract  between  the  carrier  and  the  shipper.  It  is  customarily 
drawn  up  by  the  shipper  on  forms  which  the  carrier  supplies  and 
which  are  signed  by  the  latter  after  the  receipt  of  the  goods  in  the 
case  of  a  railroad  company,  or  after  delivery  of  the  dock  receipt 
and  the  shipper's  manifest  in  the  case  of  a  shipment  abroad. 
Bills  of  lading  are  the  most  important  of  the  shipping  papers  and 
are  used  extensively  as  collateral  in  connection  with  drafts  and 
bills  of  exchange.  The  only  thing  that  makes  a  bill  of  lading  valu- 
able to  buy  or  to  use  as  collateral  is  the  fact  that  the  carrier  will 
hold  the  goods  until  the  bill  itself  is  surrendered,  except  possi- 
bly in  the  case  of  a  "  straight "  bill  of  lading. 

2.  Straight  and  Order  Bills  of  Lading. — A  straight  bill  of 
lading  states  that  the  merchandise  is  consigned  or  destined  to  a 
specified  person.  It  is  non-negotiable  and  therefore  is  not  the 
proper  form  for  use  as  collateral.  An  "order"  bill  of  lading  states 
that  the  merchandise  is  consigned  or  destined  to  the  order  of  any 
person  named  in  the  bill,  and  is  therefore  negotiable.    Such  a 

58 


IV]  COMMERCIAL  CREDIT  DOCUMENTS  59 

bill  will  make  the  merchandise  deliverable  to  the  order  of  the 
shipper  himself,  to  the  order  of  the  buyer,  or  to  the  order  of  some 
bank  which  has  agreed  to  finance  the  shipment  through  the  pur- 
chase of  the  shipper's  draft  or  through  the  issue  of  a  commercial 
letter  of  credit.  Bills  of  lading  drawn  to  the  seller's  order  are  used 
most  generally  when  a  draft  is  to  be  attached.  The  seller  indorses 
it  in  blank  and  then  delivers  it  to  his  bank  as  security  for  the  bill 
of  exchange. 

With  practically  no  exceptions  banks  discounting  drafts  se- 
cured by  bills  of  lading  insist  upon  order  bills  of  lading.  When  a 
draft  is  accompanied  by  a  straight  bill  of  lading  the  bank  as  a 
rule  receives  the  item  only  for  collection  and  does  not  credit  the 
customer's  account  until  funds  have  been  received  through  the 
correspondent  bank. 

3.  Ocean  Bill  of  Lading. — Ocean  bills  of  lading,  unlike  rail- 
road bills,  vary  in  phraseology,  due  in  part  to  the  business  cus- 
toms of  the  country  under  whose  flag  the  vessel  sails,  and  in  part 
to  the  laws  of  the  countries  between  which  the  steamer  runs. 
Different  bills  of  lading,  for  example  (although  issued  by  the 
same  steamship  company),  are  required  for  shipments  to  South 
America  and  those  destined  to  England  or  France. 

Particularly  in  foreign  trade  it  is  not  customary  for  the  ocean 
bill  of  lading  to  be  drawn  in  the  consignee's  name  (straight)  unless 
special  arrangements  have  been  made  with  the  shipper,  or  unless 
advance  payment  has  been  made  or  security  furnished  before  the 
shipment.  The  plan  for  effecting  financial  settlements  most 
commonly  employed  in  foreign  commerce  involves  drafts  or  bills 
of  exchange,  to  which  are  attached  such  documents  as  the  ocean 
bill  of  lading,  the  shipper's  invoice,  and  marine  insurance  poli- 
cies. The  number  of  copies  of  the  bill  of  lading  required  vary 
according  to  the  nature  of  the  transaction.  They  are  usually 
issued  in  sets  and  some  are  made  negotiable  and  others  non- 
negotiable.    Banks  purchasing  drafts  require  two  or  more  nego'  i- 


6o  BANKING  AND  CREDIT  [IV 

able  copies  and  insist  upon  possession  of  all  other  negotiable 
copies.  Non-negotiable  copies  are  necessary  for  the  shipper,  the 
carrier,  and  the  consignee  for  filing,  and  by  foreign  consuls  to 
comply  with  the  provisions  of  the  law. 

4.  Through  Bills  of  Lading. — "Through"  bills  of  lading,  also 
called  "export"  bills  of  lading,  are  used  where  an  exporter  at  an 
inland  point  wishes  to  bill  his  goods  from  point  of  shipment  to  the 
foreign  point  of  delivery,  port  or  interior.  By  a  through  bill  the 
exporter  avoids  the  necessity  of  obtaining  a  railroad  bill  of  lading 
to  cover  the  goods  to  the  port  of  shipment,  and  then  an  ocean 
bill  to  the  foreign  port  of  destination.  The  export  bill  of  lading, 
is,  in  effect,  a  triple  contract  embracing  three  things:  (i)  trans- 
portation by  rail  or  water  to  port  of  shipment;  (2)  transportation 
by  sea;  (3)  transportation  from  foreign  port  of  entry  to  inland 
destination. 

5.  Transaction  Illustrating  Use  of  Bill  of  Lading. — In  order 
to  understand  the  use  of  a  bill  of  lading  as  collateral  in  a  domestic 
transaction  let  us  suppose  that  Buyer  and  Company  of  Syracuse 
has  purchased  a  bill  of  goods  from  Seller  and  Company  of  Boston, 
subject  to  a  sight  draft.  Upon  receipt  of  the  goods  the  railroad 
company  signs  the  bill  of  lading  (Form  8)  made  out  by  Seller 
and  Company.  The  bill  of  lading  with  the  invoice  (Form  9)  is 
then  attached  to  a  draft  (Form  10)  drawn  in  favor  either  of  Seller 
and  Company  or  of  its  Boston  bank  and  turned  over  to  the 
latter.  The  Boston  bank  forwards  the  draft  with  the  bill  of  lading 
to  its  correspondent  in  Syracuse,  who  presents  the  draft  to  Buyer 
and  Company  for  payment.  Upon  payment  of  the  draft  Buyer 
and  Company  obtains  the  bill  of  lading  and  thus  is  in  a  position 
to  secure  the  merchandise  from  the  railroad  company.  As  soon 
as  the  Boston  bank  has  received  notice  that  the  draft  has  been 
paid,  it  advances  the  proceeds  of  the  draft  to  Seller  and  Company, 
although  the  latter  may  possibly  obtain  immediate  use  of  the 


IV 1 


COMMERCIAL  CREDIT  DOCUMENTS 


6l 


UnUonn  BUI  of  LadUig  Oorr«ct«t  to  October  10, 1620 


N.  Y.  C.  R.  R.  CO..  LESSEE 


Boston  &  Albany  Railroad 

Shippers  No._llS_ 
Agents  No 36 


ORDER  BILL  OF  LAOINQ-ORICINAL 


at 


RECEIVED,  suhject  lo  iho  rIassiBcatio 

,_aa8.tani  Masst 


B  and  tariffs  in  efTcct  oo  tbd  dato  of  ii 


'■  of  this  Original  Bill  of  LadioR, 

Qato.hex_J.9* 


^192X- 


irtyats 


from.  ,  SS  1  Xer    and  -  CornpcUiy      the  property  described  below,  in  apparent  good  order,  oxcpt  aa  Dotcd 

(contents  and  conditioo  of  cont'-nta  of  packag'-a  unknown),  marked,  consigned  and  destined  aa  indicated   below,    whirh   said  Company    agrees 
(o  carry  to  )l3  usual  place  of  delivcrv  at  said  dcsli 
It  is  mulually  agreed,  us  to  each  carrier  of  all  or  an 
timo  i  ntereated  in  all  or  any  of  said  nropcrty,  that  ( 
or  written,  herein  contained  (incluaing  conditions 

The  luprendvr  of  thra  Original  ORDER  Bill  of  Lading  properly  Indorssd  ahall  be  required  before  the  delivery  of  the  pi 
spectlon  of  propvt/  covered  by  this  bill  of  lading  will  not  be  permitted    unleap  provided  by 


road,  othernTso  to  deliver  to  another  carrier  oo  the  route 
f  said  property  overall  or  any  portion  of  said  route  to  destination  and  as 

r>'  STviec  to  ho  pi-rformM  hereunder  shall  l>e  subject  ty  all  tho  conditions,  whether    pnn'ea 
I  back  hereof)  and  which  aro  agreed  to  by  the  shipper  and  a^-cepted  for  him^f-lf  and   his 


/ 

in  Cents  J7e 

IT  E^<^l 

IT  Sp.H.1 

V.f 

!'. 

IP 

Jl 

"«° 

£ 

cL 

.',' 

"h 

cZ. 

1    " 

IP       1       IF 

P" 

1 

Consigned  to  ORDER  OF Sellat-and_Co mp a.Tl  jE- 

Destination, ,        SyT  aOUS  8,  .  

Notify Buyer  and  Company,.. 

At..... Syracuse 

Route,   ...B.    &.  A.;    H.y.C.       


..state  of.HaW...YQXlt County  of... 


-95a-Harrlann  St,... 


5tate  of.H.9W...Xat.lsCounty  of 

-Car  Initial Car  No.. 


One 
J[hq_ 


DESCRIPTION  OF  ARTICLES  AND  SPECIAL  MARKS  I 


(1)    Casa  Leather,  Mahogany  Sides  I  850  lbs 
XSiBuQdlaa.  ^9fl.t,^fl^,llah^eany  sidna  160 


Syracuse' 


If  charges  are  to  be 
prepaid,  write  or  stamp 
here,  "To  be  Prepaid." 


Received  $         

to  apply  in  prepayment 
of  the  charges  on  the 
property  described  hereon. 


Charges  Advanced 


5?.l,ier .  and  .Coiupany shipper    l/Jji:.  .«/.*-*>^r.' 


.Agent 


.a..Y.s. 


(Tliia  Bia  ot  t4iliii«  1*  to  b«  aUned  by  Um  .Upiwt  4Bd  •!«><  oLt^  tamer  bminc  amej 


Form  8.     Railroad  Bill  of  Lading 

The  railroad  bill  of  lading  illustrated  above  is  made  out  by  Seller  and  Company  in  trip- 
licate and  the  different  copies  are  referred  to  as:  (i)  original  bill  of  lading.  (2)  shipping 
order,  and  (3)  memorandum  bill  of  lading.  All  copies  of  the  bill  of  lading  are  sigried  by 
the  railroad  agent  upon  receipt  of  the  goods.  The  original  bill  of  lading,  to  which  are 
attached  the  sight  draft  and  invoice,  goes  to  Seller  and  Company's  Boston  bank.  The 
shipping  order  is  retained  by  the  railroad  company,  and  the  memorandum  bill  of  lading  is 
kept  by  Seller  and  Company  for  filing  purposes.  Seller  and  Company  may,  if  it  wishes, 
make  out  extra  copies  of  the  memorandum  bill  of  lading. 


62 


BANKING  AND  CREDIT 


IV 


proceeds  of  the  bill  upon  depositing  it  with  the  bank.    The  Boston 
bank  would  be  safe  in  advancing  funds  to  its  customer  because  it 


CABLE  ADDRESS  NEW  YORK  OFFICE 

"SELACO"  ^■w-.-w   ■r   T-iTv         •  '^T'v^       .^.«-^'>a"rv   •  v^rvT-  '84  GOLD  ST. 

A.B.c.(5TH  EDITION)  SELLER  AND  COMPANY 

AND  LIEBERS  CODES      »-'■*-••"*-•*-'■»•     ^■^■^^'^      v^va..ii  .li-x^  i 

Leather  Manufacturers 

1204   LINCOLN  STREET 

BOSTON.  MASS.  U.S.A.  Jan.  31/1922 

Goi  n  TO  Buyer  and  Company 

s,oi_u  lu  g^Q  Harrison  St.  ,  Syracuse  ,  U.Y . 

TERMS  5%  Cash  Dls't       %1ir''^°B.&:  A.K  Y.  C.  OnecAsesTwo  bundles 


20 


240 


Sight  Draft  fo:r 


A.L.I 


NUGXOS 
Patent 
Sides 


i825 
Less 


50^ 


.912.50 


ma 


above  amount 
The  Atlas  Na 


5%  Cash 

,  ri-;  o,  ^  J-,-, 


Trade  Piscount   95.65 
U816.87 


de  uoon you  through 
tionapLBank  of  Boston 


Form  9.     Shipper's  Invoice 

This  invoice  and  the  draft  are  attached  to  the  original  bill  of  lading  and  are  turned  over 
by  Seller  and  Company  to  its  Boston  bank 

retains  title  to  the  bill  of  lading  and,  therefore,  the  goods,  until  its 
Syracuse  correspondent  secures  payment  from  Buyer  and  Com- 
pany. The  funds  will  probably  be  forwarded  from  Syracuse  in 
the  form  of  a  Boston  or  New  York  bank  draft.  If  Buyer  and 
Company  refuses  payment  the  Boston  bank  can  recover  from 
Seller  and  Company. 


6.  Negotiability  of  Bills  of  Lading. — Although  the  bulk  of  the 
cotton,  grain,  and  other  commodities  moving  to  market  are 
financed  on  the  basis  of  bills  of  lading  attached  to  drafts,  the  prac- 
tice in  the  past  has  been  subject  to  grave  abuses  and  fraudulent 
methods.  In  order  to  provide  protection  against  drafts  with 
bogus  bills  of  lading  and  other  easy  means  of  obtaining  money 


IV]  COMMERCIAL  CREDIT  DOCUMENTS  63 

fraudulently,  Congress  passed  a  Bill  of  Lading  Act  which  became 
effective  January  i,  1917.     The  main  features  of  this  act  are: 

1.  Provision  for  a  uniform  domestic  bill  of  lading  which  is 

easily  and  safely  negotiable. 

2.  The  shifting  of  the  burden  of  responsibility  from  the  bank 

to  the  carrier. 

3.  Declaring  that  fraudulent  practices  in  connection  with 

such  bills  are  misdemeanors  and  punishable  by  fine  or 
imprisonment  or  both. 


o 


$1816.87  Boston,  Jan.  ji,  IQ22 

At  Sight Pay  to 

the  order  of Atlas  National  Bank  of  Boston 

Eighteen  Hundred  Sixteen iifo  Dollars 

Value  received  and  charge  the  same  to  account  of 

To  Buyer  and  Company  1  vSeller  and  Company 

9S8  Harrison  St.,  Syracuse,  N.  Y.     I  H.  C.  Carter 

Pres. 


Form  10.     vShipper's  Draft 

This  draft  and  the  invoice  are  attached  to  the  original  bill  of  lading  and  are  turned  over 
by  Seller  and  Company  to  its  Boston  bank 

Bills  of  lading  do  not  possess  full  negotiability  in  the  strict 
sense  of  the  word.  And,  indeed,  it  will  never  be  possible  for  them 
to  meet  the  requirements  of  the  true  negotiable  instrument,  be- 
cause one  of  these  requirements  is  that  the  instrument  must  con- 
tain an  unconditional  promise  or  order  to  pay  a  certain  sum  of 
money.  However,  a  bill  of  lading  is  negotiable  in  the  sense  that 
it  is  transferable  by  indorsement  and  delivery  and  that  such  in- 
dorsement and  delivery  transfer  to  the  indorsee  or  holder  rights 
to  or  property  in  the  goods. 


64 


BANKING  AND  CREDIT 


IV 


7.  Warehouse  Receipts. — In  recent  years  there  has  been  a 
rapid  development  in  the  use  of  the  warehouse  receipt  (Form  11) 
as  collateral.  This  is  an  evidence  not  only  of  the  close  relation- 
ship between  the  banker  and  the  storage  warehouseman  but  also 


Form  II.     Warehouse  Receipt 


of  the  parts  played  by  both  in  the  distribution  of  raw  products 
and  manufactured  goods.  As  the  population  and  industries  of 
our  cities  increase,  the  problems  of  handling  seasonal  accumula- 
tions of  goods  and  of  bringing  them  from  the  producer's  to  the 
consumer's  market  become  greater  and  make  the  service  of  the 
storage  warehouseman  more  indispensable  than  ever. 

There  is  in  effect,  with  a  few  minor  variations,  a  uniform 
warehouse  receipts  act  in  nearly  every  state  of  the  Union.  The 
following  statements  concerning  this  law  are  summarized  in  part 
from  a  pamphlet  published  by  the  American  Warehousemen's 
Association:^ 


'  Warehouse  Receipts  as  Collateral,  pp.  3-6. 


IV]  COMMERCIAL  CREDIT  DOCUMENTS  65 

A  warehouse  receipt  is  an  acknowledgment  of  the  warehouse- 
man that  he  has  received  for  storage  certain  goods  which  will 
be  delivered  on  demand,  provided  the  terms  of  the  receipt  are 
complied  with.  The  Uniform  Warehouse  Receipts  Act  specifies 
two  distinct  forms  of  warehouse  receipt — negotiable  and  non- 
negotiable. 

In  order  to  be  negotiable  a  receipt  must  state  that  the  goods 
received  will  be  delivered  to:  (i)  the  bearer,  or  (2)  a  specified 
person  or  on  his  order.  A  non-negotiable  receipt  states  that  the 
goods  covered  by  it  will  be  delivered  to  the  depositor  only,  or  only 
to  a  specified  person  named  in  the  receipt. 

The  pamphlet  of  the  American  Warehousemen's  Association 
further  states : 

The  two  forms  of  receipts  differ  in  actual  use  chiefly  as  to  the 
manner  in  which  right  of  possession  of  the  goods  covered  by  the 
receipts  may  pass  from  one  party  to  another,  and  the  manner  in 
which  delivery  of  the  goods  can  be  effected. 

A  negotiable  receipt  may  pass  from  hand  to  hand  merely  by 
indorsement  in  much  the  same  manner  as  any  other  negotiable 
instrument.  Right  of  possession  of  the  goods  covered  by  a  negoti- 
able receipt  follows  the  ownership  and  possession  of  the  receipt. 
Lawful  delivery  of  goods  covered  by  a  negotiable  warehouse 
receipt  cannot  be  made  without  the  surrender  of  the  receipt 
properly  endorsed.  Care  must  be  exercised  by  the  holder  of  a 
negotiable  receipt  that  it  be  not  lost,  misplaced  or  destroyed. 

The  surrender  of  a  non-negotiable  warehouse  receipt  is  not 
required  by  law.  Delivery  of  goods  covered  by  such  a  receipt,  or 
transfer  of  the  right  to  delivery  on  the  books  of  the  warehouse- 
man, is  accomplished  through  the  written  order  of  the  party  in 
whose  name  the  goods  are  stored.  Non-negotiable  receipts  must 
be  so  marked.  Failure  so  to  do  may  require  the  warehouseman 
to  treat  such  receipts  as  negotiable. 

A  banker  may,  with  reasonable  safety,  accept  as  collateral  a 
duly  endorsed  negotiable  receipt  issued  by  a  reputable  warehouse-  j 
man,  provided  he  is  satisfied  with  the  endorsements  and  is  sure 
that  the  goods  are  as  represented.  Care  should,  of  course,  be 
exercised  Lo  see  that  storage  charges  and  other  liens  are  fully  paid 
5 


66  BANKING  AND  CREDIT  [  IV 

through  having  receipted  bills  of  the  warehouseman  filed  with 
him  monthly.  In  case  the  borrower  desires  to  take  delivery  of  a 
portion  of  the  goods  covered  by  a  negotiable  receipt,  it  is  neces- 
sary to  either  present  the  receipt  to  the  warehouseman  in  order 
that  there  may  be  noted  upon  it  the  release  of  the  quantity  de- 
livered, or  surrender  the  original  receipt  and  obtain  a  new  one  for 
the  goods  remaining  undelivered. 

When  money  is  to  be  loaned  on  goods  in  storage  and  the 
banker  obtains  a  non-negotiable  receipt  in  his  own  name,  the 
goods  are  under  his  sole  control.  In  such  a  case  the  warehouse- 
man will  not  permit  delivery,  or  even  inspection,  of  the  goods 
without  the  written  authority  of  the  banker.  In  case  the  bor- 
rower is  involved  in  litigation,  an  attachment  of  the  goods  will 
not  prevail  as  long  as  the  receipt  is  in  the  name  of  the  banker. 
The  banker  assumes  no  liability  or  diminution  of  security  in  the 
event  of  loss,  misplacement  or  destruction  of  such  a  receipt, since 
the  goods  cannot  be  released  without  his  written  order.  Partial 
deliveries  can  be  made  merely  on  the  written  order  of  the  banker. 
Most  of  the  warehousemen  of  the  country  issue  non-negotiable 
receipts  in  exchange  for  negotiable  receipts,  or  transfer  goods 
covered  by  a  non-negotiable  receipt  to  another  party,  without 
making  a  charge  for  the  additional  non-negotiable  receipt  re- 
quired. 

For  collateral  use  the  American  Warehousemen's  Association 
recommends  the  non-negotiable  warehouse  receipt  in  the  name 
of  the  banker  as  compared  with  the  negotiable  form. 

In  the  East,  and  particularly  in  New  England,  the  use  of  the 
non-negotiable  form  as  collateral  is  increasing. 

8.  Commodity  Paper. — Bills  of  exchange  and  promissory 
notes  secured  by  warehouse  receipts  as  collateral  are  called  "com- 
modity paper."  In  case  of  default  of  payment  by  the  borrower 
the  bank  is  empowered  to  take  possession  of  the  goods  and  sell 
them  to  satisfy  the  debt.  If  a  borrower  wishes  to  sell  some  of  the 
produce  covered  by  a  warehouse  receipt  before  the  maturity  of 
the  loan,  he  is  usually  required  to  reduce  his  obligation  by  a  cor- 
responding amount  or  to  substitute  other  receipts. 


IV]  COMMERCIAL  CREDIT  DOCUMENTS  67 

Some  warehouse  receipts  guarantee  grades,  weights,  and  other 
essential  qualities,  although  often  stipulating  certain  variations. 
A  charge  is  sometimes  made  for  this  guaranty;  in  cotton,  for 
example,  a  customary  fee  is  1/ 16  of  a  cent  per  pound. 

According  to  the  rulings  of  the  Federal  Reserve  Board  no  draft 
which  is  secured  by  a  warehouse  receipt  is  eligible  for  acceptance 
unless  the  goods  covered  by  the  receipt  are  being  held  in  storage 
pending  a  reasonably  immediate  sale,  shipment,  or  distribution. 
Any  draft,  therefore,  which  is  drawn  to  carry  goods  for  specula- 
tive purposes  or  for  any  indefinite  period  is  not  considered  eligible 
for  acceptance.  Warehouse  receipts  offered  as  security  for  bills 
accepted  by  member  banks  of  the  federal  reserve  system  must  be 
issued  by  warehouses  which  are  independent  of  the  borrower. 

9.  Warehousing  System  in  Louisiana. — The  state  of  Louis- 
iana has  in  recent  years  developed  an  excellent  warehousing  sys- 
tem which  is  designed  to  accomplish  among  other  things  the  pre- 
vention of  losses  experienced  in  the  past  where  the  borrower  con- 
trolled the  warehouse.  Under  the  administration  of  the  Board  of 
Commissions  of  the  Port  of  New  Orleans  the  produce  covered  by 
a  warehouse  receipt  is  deliverable  only  to  the  order  of  the  deposi- 
tor upon  surrender  of  the  receipt.  These  receipts  are  never  issued 
to  bearer,  but  the  owner  of  the  merchandise  may  indorse  them, 
"Deliver  to  bearer."  All  grain  stored  in  elevators  or  warehouses 
is  graded  and  the  receipts  specify  the  quantity  and  grade.  Cotton, 
sugar,  rice,  and  other  commodities  are  not  graded  and  conse- 
quently the  loaning  bank  in  judging  the  statements  of  its  cus- 
tomer as  to  grade  must  rely  on  its  knowledge  of  his  integrity  and 
financial  standing.  When  commodities  have  been  placed  in  ware- 
houses in  the  case  of  a  loan,  insurance  must  be  provided  for  by 
the  depositor  and  the  policies  turned  over  to  the  bank.  The 
insurance  policies  are  usually  made  to  the  order  of  the  depositor 
and  are  then  indorsed  in  blank.  Frequently,  however,  insurance 
is  negotiated  through  an  open  policy  which  is  issued  for  a  specified 


68  BANKING  AND  CREDIT  [IV 

amount  and  which  covers  the  commodities  while  waiting  ship- 
ment in  warehouses,  compresses,  or  on  wharves,  docks,  levees,  or 
elsewhere  on  land  in  the  United  States. 

ID.  Trust  Receipts. — Trust  receipts  (Form  12)  are  sometimes 
accepted  by  a  bank  as  temporary  collateral  from  responsible 


TRUST  RECEIPT 

Documents  for  Warehousing 

Received  from  The  Colonial  Trust  Company  of  New  York  Bill 

of  Lading  per   ...Prince  Line...  dated    ...May  29,    IQ22 . . .    for  the 

following  goods  and  merchandise,  their  property,  marked  and  numbered 

as  follows: 


R&  Co. 

N.  Y. 


.dry  hides. 


imported  under  the  terms  of  Letter  of  Credit  No.  . .  .14672 . . .,  issued 
by  them  for  our  account  the  said  Bill  of  Lading  to  be  used  by  us  for  the 
sole  purpose  of  entering  the  above  described  property  at  the  United 

States  Custom  House  at  the  Port  of    New  York  City,....  and 

of  storing  the  same  in  the  name,  and  as  the  property,  of  the  said  The 
Colonial  Trust  Company  of  New  York,  and  subject  only  to  their 
order,  we  hereby  agreeing  to  so  store  the  said  property  and  to  hand  the 
storage  receipt  for  the  same  to  the  said  The  Colonlvl  Trust  Company 
OF  New  York,  when  obtained. 

We  Also  Agree  to  fully  insure  said  property  against  fire;  the  loss,  if 
any,  payable  to  said  The  Coloni.al  Trust  Company  of  New  York, 
and  to  hand  to  them  the  policies  of  insurance  thereon. 

Dated lime  26,  1922 

(Signed)  Rand  and  Company 
$49,650  Per  R.  L.  Rand 

Treasurer 


Form  12.     Trust  Receipt 

This  form  of  trust  receipt  is  also  used  in  connection  with  import  letters  of  credit,  and  it  is 
temporarily  accepted  against  the  surrender  of  shipping  documents  in  order  that  the  goods 
covered  by  such  documents  may  be  placed  in  warehouse,  and  pending  the  delivery  of  the 

warehouse  receipt 


IV]  COMMERCIAL  CREDIT  DOCUMENTS  69 

customers  in  exchange  for  shipping  documents  or  warehouse 
receipts.  They  are  also  used  in  connection  with  import  and  ex- 
port letters  of  credit  and  loans.  Trust  receipts  vary  in  terms  and 
in  form,  depending  on  the  nature  of  the  transaction  and  the  de- 
gree of  risk  the  bank  is  willing  to  assume.  For  instance,  one  form 
of  trust  receipt  is  used  when  the  merchandise  against  which  the 
bank  has  advanced  funds  remains  in  the  control  of  its  customer. 
Another  form  is  used  to  cover  the  delivery  of  merchandise  actu- 
ally sold  and  is  also  used  in  connection  with  import  letters  of 
credit  when  the  relative  shipping  documents  have  been  sur- 
rendered to  the  customer  in  order  to  enable  him  to  make  delivery 
to  the  buyer.  Another  form  is  used  in  connection  with  import 
letters  of  credit  and  is  temporarily  accepted  against  the  surrender 
of  shipping  documents  for  the  purpose  of  enabling  the  bank's 
client  to  place  the  merchandise  in  warehouse  and  pending  the 
delivery  of  the  warehouse  receipt.  Still  another  form,  known  as  a 
"bailee  receipt,"  is  very  specific  as  to  the  terms  and  conditions 
under  which  the  client  of  the  bank  is  permitted  to  obtain  posses- 
sion of  the  merchandise. 

In  general,  trust  receipts  specify  that  the  title  to  the  goods  is 
with  the  bank  and  that  they  are  being  held  in  trust  by  the  cus- 
tomer who  agrees  to  turn  over  to  the  bank  the  proceeds  from  their 
sale  until  the  total  debt  is  settled.  The  bank  is  empowered  to 
take  possession  of  the  goods  at  any  time,  although  if  this  action 
should  be  considered  necessary  because  of  financial  embarrass- 
ment of  the  customer,  no  little  difficulty  might  be  experienced  in 
determining  which  of  the  goods  were  covered  by  the  trust  receipt. 
As  a  matter  of  practice  banks,  while  reserving  the  right  to  enforce 
the  provisions  of  a  trust  receipt,  usually  allow  the  customer  more 
leeway  in  settling  his  obligations. 

II.  Hypothecation  Certificate. — To  hypothecate  means  to 
give  personal  property  as  a  pledge  to  secure  a  note,  draft,  or  other 
obligation.     Hypothecation  certificates  are  commonly  used  to 


70  BANKING  AND  CREDIT  [  IV 

pledge  collateral  securities  on  call  loans  and  shipping  documents 
in  connection  with  foreign  documentary  bills.  Although  not  an 
indispensable  procedure  to  protect  its  legal  rights,  it  is  the  general 
practice  for  a  bank,  which  expects  to  purchase  from  a  given  con- 
cern documentary  bills,  to  require  the  firm  to  sign  a  hypotheca- 
tion certificate ;  this  document  makes  the  legal  acknowledgment 
which  constitutes  the  bank  or  any  other  holder  of  the  draft  also  a 
holder  of  the  bills  of  lading  and  insurance  certificates  as  collateral 
security.  Where  a  large  number  of  drafts  are  to  be  purchased  the 
instrument  often  takes  the  form  of  a  general  letter  of  hypotheca- 
tion covering  all  the  bills  which  are  negotiated  to  the  bank  by  its 
customer  during  the  life  of  the  letter. 

References 

American    Warehousemen's  Association.       Warehouse  Receipts  as  Col- 
lateral. 
Exporters'  Encyclopedia. 

Consult  table  of  contents  under  Bills  of  Lading,  Consular  Docu- 
ments, Inspection  of  Certificates. 
Johnson,  E.  R.,  and  Huebner,  G.  G.     Railroad  Trafiic  and  Rates. 

Bills  of  lading.  Vol.  I,  pp.  98-105. 
Moulton,  H.  G.     Financial  Organization  of  Society. 

Bills  of  lading  and  warehouse  receipts,  pp.  394-400;  trust  receipts, 

P-  415- 
Snider,  G.  E.,  Maule,  W.  M.,  and  MacElwee,  R.  S.     Paper  Work  in 

Export  Trade.     (United  States  Bureau  of  Foreign  and  Domestic 

Commerce.     Miscellaneous  Series  No.  85.) 
Westerfield,  R.  B.     Banking  Principles  and  Practice. 

Bills  of  lading.  Vol.  IV,  pp.  913-924;  warehouse  receipts.  Vol.  IV, 

pp.  898-912;  trust  receipts,  Vol.  V,  p.  1272. 
Willis,  H.  P.,  and  Edwards,  G.  M.     Banking  and  Business,  pp.  271-274. 


CHAPTER  V 
LETTERS  OF  CREDIT 

1.  Purpose  of  Letters  of  Credit. — Letters  of  credit  may  be 
classified  according  to  whether  they  are  issued  to  facilitate  financ- 
ing trade,  that  is,  commercial  letters  of  credit,  or  to  furnish  the 
traveler  with  funds,  that  is,  travelers'  letters  of  credit.  Both  of 
these  are  issued  by  banks  and  are  in  effect  statements  of  authori- 
zation and  undertaking.  The  beneficiary  is  authorized  to  draw 
drafts  and  the  issuing  bank  undertakes  to  have  them  honored. 
Closely  akin  to  a  commercial  letter  of  credit  in  purpose,  but  used 
much  less  frequently,  is  an  "authority  to  purchase." 

2.  Import  and  Export  Letters  of  Credit.' — Import  and  export 
letters  of  credit  (Form  13)  are  instruments  designed  for  the  pur- 
pose of  enabling  exporters  to  draw  their  drafts  upon  a  bank  in- 
stead of  upon  the  importers  to  whom  the  merchandise  has  been 
sold.  The  two  principal  ways  in  which  an  exporter  may  receive 
payment  for  a  shipment  of  goods  are:  (i)  by  drawing  a  bill  of 
exchange,  and  (2)  by  receiving  a  remittance  of  exchange,  either 
directly  from  the  importer  or  indirectly  through  a  bank.  If  the 
exporter  draws,  the  drawee  may  be  either  the  importer  or  some 
banking  institution  which  has  agreed  to  act  for  the  importer. 
When  an  importer  has  made  the  necessary  arrangements  to  allow 
the  exporter  to  draw  on  a  bank,  this  right  to  draw  bills  against 
merchandise  shipments  is  known  as  a  "commercial  credit"  and 
also  a ' '  bank  credit . ' '  The  instrument  which  testifies  to  or  afhrms 
the  opening  of  this  credit  at  a  bank  is  called  an  "import  letter  of 
credit"  or  an  "export  letter  of  credit,"  as  the  case  may  be;  the 


'  Commercial  letters  of  credit  are  also  dealt  with  in  the  chapters  on  foreign  exchange. 

71 


72  BANKING  AND  CREDIT  [V 


Colonial  Trust  Company  of  New  York 
Credit  No.  14672 

$50,000  U.  S.  C.  Foreign  Department 

Lopez  &  Stevenson  New  York,  April  12,  ig22 

Buenos  Aires,  Argentina 

Dear  Sirs: 

At  the  request  and  for  the  account  of  . . .  Rand  £f  Company,  New 
York, ...  we  hereby  authorize  you  to  value  on 

Colonial  Trust  Company  of  New  York,  New  York 

at  . . .  Four  {4)  Months  sight  . . .  for  the  sum  or  sums  not  exceeding  a  total 

of Fifty  thousand  dollars  {$50,000) 

accompanied  by  commercial  invoice,  consular  invoice,  bills  of  lading, 
and Marine  insurance  certificates representing cost,  insur- 
ance and  freight shipment  of    ....  dry  hides  from  Buenos  Aires, 

A  rgentina,  to  New    York 

Insurance Marine  insurance  to  be  effected  by  the  shippers 

Bills  of  lading  for  such  shipments  must  be  drawn  to  the  order  of 
Colonial  Trust  Company  of  New  York,  New  York 

A  Copy  of  the  Consular  Invoice  and  One  Bill  of  Lading  must 
BE  Sent  by  the  Bank  Negotiating  Drafts,  Direct  to  Colonlvl 
Trust  Company  of  New  York,  —  New  York. 

The  amount  of  each  draft  negotiated  must  be  endorsed  hereon. 

We  hereby  agree  with  bona  fide  holders  that  all  drafts  drawn  by 
virtue  of  this  Credit,  and  in  accordance  with  the  above  stipulated  terms, 
shall  meet  with  due  honor  upon  presentation  at  the  Colonial  Trust  Com- 
pany of  New  York,  New  York,  if  drawn  and  negotiated  prior  to  . . .  Jidy 
31,  1922 

Colonial  Trust  Company  of  New  York 

N.  B.  Drafts  drawn  under  this 
Credit  must  bear  the  clause 
"drawn  under  Letter  of  Credit 
^o.  14672.     Dated,  April  12,  ig22" 

Form  13.     Import  Letter  of  Credit  (Dollars) 
Issued  in  duplicate — original  copy  shown 


V]  LETTERS  OF  CREDIT  73 

term  "commercial  letter  of  credit"  is  commonly  used  to  refer  to 
both.  The  commercial  letter  of  credit  is  essentially  a  statement  of 
information  addressed  to  the  merchant,  who  is  thereby  authorized 
to  draw  drafts  on  the  bank  under  certain  conditions  which  are 
specified.  Of  importance  from  the  legal  viewpoint  is  the  fact  that 
the  commercial  letter  of  credit  is  not  merely  an  authorization  but 
also  an  undertaking  on  the  part  of  the  issuing  bank,  which  assures 
the  exporter  that  his  drafts  will  be  honored  when  he  complies  with 
the  required  terms. 

Commercial  letters  of  credit  are  accepted  readily  by  merchants 
in  any  part  of  the  world,  because  they  know  that  as  soon  as  the 
merchandise  has  been  shipped  they  can  obtain  reimbursement 
through  their  local  banks  by  presenting  the  credit  together  with 
the  documents  stipulated.  The  details  of  a  letter  of  credit  are 
matters  for  arrangement  between  the  importer  and  the  foreign 
shipper.  Letters  of  credit  can,  when  necessary,  be  established  by 
cable,  saving  the  delay  in  waiting  for  their  transmission  by  mail. 
The  commissions  charged  for  bank  credits  are  roughly  propor- 
tional to  the  length  of  life  or  usance  of  the  drafts,  and  vary  or- 
dinarily from  >4  to  >^  per  cent  on  sight  drafts,  to  V  s  to  i  per  cent 
on  drafts  to  be  drawn  at  4  and  6  months.  Frequently  concessions 
from  these  rates  are  made  in  favor  of  houses  of  prime  standing 
that  have  large  and  regular  dealings  with  the  bank. 

3.  Advantages  of  Letters  of  Credit  in  Foreign  Trade. — The 

extensive  use  of  letters  of  credit  is  not  to  be  wondered  at  when 
their  many  advantages  both  to  the  importer  and  to  the  exporter 
are  considered.  By  means  of  a  letter  of  credit  an  importer  can 
readily  obtain  goods  from  foreign  merchants  who  ordinarily 
cannot  be  expected  to  know  or  rely  upon  his  business  standing. 
Furthermore  these  purchases  can  be  made  where  the  exporter 
requires  cash  at  the  time  of  shipment.  The  importer  may  with 
safety  give  advance  orders  for  goods  for  future  delivery  and  may 
make  immediate  arrangements  for  their  manufacture  or  sale. 


74  BANKING  AND  CREDIT  [V 

By  the  system  of  letters  of  credit  the  importer  is  enabled  to  fi- 
nance the  shipment  of  his  merchandise  by  borrowing  funds  ul- 
timately from  the  world's  monetary  centers  at  the  comparatively 
low  rates  of  interest  regularly  prevailing  there.  Finally,  from  the 
viewpoint  of  the  importer  there  is  afforded  the  greatest  security 
practically  possible  against  collection  of  cash  by  the  exporter 
without  the  performance  of  his  part  of  the  mercantile  contract, 
namely,  the  shipment  of  the  goods. 

Decided  benefits  from  the  letter  of  credit  system  accrue  also 
to  the  exporter.  Protected  by  a  letter  of  credit  he  may,  upon 
receipt  of  instructions  from  the  foreign  buyer,  with  reasonable 
safety  begin  manufacturing  or  collecting  merchandise  for  later 
shipment.  He  is  enabled  to  obtain  cash  payment  in  full  for 
merchandise  immediately  upon  shipment.  Finally,  since  the 
draft  drawn  by  the  exporter  is  specifically  authorized  by  a  bank, 
the  danger  of  its  dishonor,  and  therefore  the  contingent  liability 
of  the  exporter  as  drawer,  is  reduced  to  a  negligible  minimum. 

4.  Domestic  Letters  of  Credit. — Domestic  letters  of  credit  are 
generally  used  in  financing  export  and  import  shipments  between 
the  interior  and  the  seaboard  and  are  similar  to  foreign  letters  of 
credit  in  form  and  operation.  But  whereas  the  ocean  bill  of  lading 
is  the  principal  document  used  in  connection  with  a  foreign  letter 
of  credit,  in  the  case  of  a  domestic  letter  of  credit  railroad  bills  of 
lading  and  warehouse  receipts  act  as  collateral  security. 

To  illustrate:  An  exporter  in  New  York  requests  his  bank  to' 
open  a  domestic  credit  in  favor  of  a  manufacturer  in  Detroit. 
A  letter  of  credit  stating  the  terms,  i.e.,  sight,  30  days,  etc.,  under 
which  the  manufacturer  is  to  be  reimbursed  will  be  issued  to  the 
exporter,  who  will  mail  it  to  the  manufacturer.  The  latter,  after 
having  delivered  his  goods  to  the  railroad  company,  receives 
railroad  bills  of  lading,  which  he  presents  to  his  Detroit  bank. 
This  bank  makes  payment  to  the  manufacturer  in  conformity 
with  the  terms  of  the  credit  and  forwards  the  documents  to  the 


V]  LETTERS  OF  CREDIT  75 

New  York  bank  which  then,  in  return  for  a  trust  receipt,  hands 
the  railroad  bills  of  lading  to  the  exporter  who  has  established 
the  credit.  When  the  shipment  of  goods  reaches  New  York  the 
exporter  surrenders  the  railroad  bills  of  lading,  takes  possession 
of  the  goods,  and  forwards  them  to  an  ocean  steamer,  receiving 
ocean  bills  of  lading  in  return. 

5.  Authority  to  Purchase. — An  "authority  to  purchase"  is  a 
credit  document  which  is  used  only  in  trade  with  the  Orient  and  is 
issued  almost  solely  by  far  eastern  banks  to  facilitate  the  financ- 
ing of  imports  from  the  United  States.  Only  occasionally  is  an 
authority  to  purchase  issued  by  an  American  bank  to  cover  im- 
ports into  the  United  States.  In  the  past,  inadequate  banking 
facilities  in  the  Orient,  and  in  China  in  particular,  have  made  it 
practically  impossible  to  use  the  regular  commercial  letter  of 
credit.  Consequently  it  has  been  necessary  for  the  American 
exporter  to  draw  directly  on  the  Chinese  merchant.  The  latter, 
in  order  to  furnish  the  American  exporter  with  a  market  for  his 
drafts,  arranges  through  a  Chinese  bank  to  issue  an  authority  to 
purchase.  This  instrument  is  in  effect  a  letter  of  guaranty  and 
gives  the  expvVrter  assurance  that  he  will  be  able  to  sell  or  negoti- 
ate his  draft  at  the  time  of  shipment.  The  exporter  is  not  em- 
powered to  draw  on  a  bank,  but  draws  directly  on  the  importer. 
The  real  purchaser  of  the  draft  will  be  the  importer's  bank,  to 
whom  the  importer  is  known,  and  not  the  bank  in  the  country  of 
the  exporter.  However,  a  bank  in  the  exporter's  country  will, 
as  agent,  make  the  payment  of  money  to  the  exporter  and  will 
then  forward  the  draft  to  the  bank  which  issued  the  authority  to 
purchase. 

6.  Travelers'  Letters  of  Credit. — The  travelers'  letter  of  credit 
(Forms  14  a  and  b)  is  a  statement  issued  by  a  bank,  usually  in  the 
form  of  a  circular  letter  to  its  correspondents  in  specified  places 
throughout  the  world,  informing  them   that  the  traveler  or 


76  BANKING  AND  CREDIT  | 

Colonial  Trust  Company  of  New  York 
CIRCULAR  LETTER  OF  CREDIT 

No.  21,600  £.   ...2,000^ 

New  York,  February  20,  1922 
Gentlemen; 

We  beg  to  introduce  to  you  and  to  commend  to  your  courtesies 

Mr R.  P.  Stuart in  whose  favor  we  have  opened  a  credit  of 

Two  thousand Pounds  Sterling,  and  whose  drafts  to  that  ex- 
tent, at  sight,  upon  the 

Colonial  Trust  Company  of  New  York,  London, 
64  Lombard  Street 

we  engage  shall  meet  with  due  honor  if  negotiated  within  . . .  nine  . . . 
months  from  this  date. 

The  amount  of  each  payment  must  be  endorsed  on  this  letter,  and 
your  negotiation  of  the  drafts  will  be  considered  a  guarantee  that  the 
requisite  endorsements  have  been  made. 

You  will  please  observe  that  all  such  drafts  be  marked  as  "Drawn 
against  the  Colonial  Trust  Company  of  New  York  Letter  of  Credit  No. 
21,600." 

This  letter  must  be  attached  to  the  last  draft  drawn. 

We  remain  Dear  Sirs, 

Yours  faithfully, 
[Signature  of] 

R.  P.  Stuart  Norman  A.  Little 

Vice-President 


Raymond  D.  Atwell 

Secretary 


To  Messieurs  Our  Correspondents 


Form  14.     (a)  Travelers'  Sterling  Letter  of  Credit  (face) 


V] 


LETTERS  OF  CREDIT 


77 


Specificatiox 
Of  all  Payments  Made  Under  This  Lettfr  of  Credit 

(Please  endorse  all  payments  in  Pounds  Sterling  currency  in  which  this 
credit  is  issued.) 

Date 
When  Paid 

Paid  By 

Sterling  Amounts 
In  Word 

Sterling 
Amounts 
In  Figures 

Mur. 

-',>--'-' 

Far  Eastern  Bank 
Shanghai 

T'urnty  pounds  Stg. 

£20 

0 

0 

Apr. 

10/22 

Oriental  Bank 

Singapore 

Sixty  pounds  Stg. 

£60 

0 

0 

Amount  carried  forward 

Form  14.     (b)  Travelers'  Sterling  Letter  of  Credit  (reverse) 


78  BANKING  AND  CREDIT  IV 

beneficiary  is  authorized  to  draw  sight  drafts  for  any  amount  not 
exceeding  a  specified  sum  either  on  the  issuing  bank  itself  or  on 
a  central  correspondent  named  in  the  letter,  usually  one  in  Lon- 
don. Travelers' letters  of  credit  may  be  classified  as:  (i)  domestic, 
which  are  drawn  in  local  currency  for  use  in  the  country  where 
they  are  issued,  and  (2)  foreign,  which  before  the  war  were  usu- 
ally drawn  in  sterling  but  which  are  at  present  also  drawn  to  a 
large  extent  in  dollars.  At  the  time  of  purchase  the  traveler  is 
required  to  sign  his  name  upon  the  document  and  also  upon  a 
letter  of  indication  (or  identification)  and  is  advised  to  keep  the 
two  letters  apart.  When  the  traveler  desires  funds  he  presents 
his  letter  to  the  proper  bank  at  the  place  where  he  is  stopping. 
The  banker  to  whom  the  letter  is  presented  for  payment  will  draw 
a  sight  draft  on  the  issuing  bank  or  its  central  correspondent 
abroad,  and  will  require  the  traveler  to  sign  it.  The  ability  of 
the  traveler  to  reproduce  his  signature  placed  upon  the  letter  at 
the  time  of  its  delivery  to  him  or  upon  the  separate  letter  of  in- 
dication will  serve  to  identify  him. 

Just  as  in  the  case  of  commercial  letters  of  credit,  when  drafts 
are  drawn  they  are  recorded  on  an  appropriate  page,  and  when 
the  credit  has  been  exhausted  the  letter  will  be  retained  by  the 
bank  that  has  cashed  the  last  draft  and  will  be  forwarded  to- 
gether with  the  draft  to  be  surrendered  to  the  drawee  bank.  If 
the  traveler  comes  home  without  having  exhausted  the  credit,  his 
bank  will  refund  the  balance  that  has  not  been  used. 

Only  the  larger  banks  issue  their  own  letters  of  credit,  whether 
these  authorize  drafts  upon  themselves  or  upon  central  corre- 
spondents abroad.  Many  smaller  banks  have  arrangements 
whereby  they  can  issue  letters  practically  as  agents  of  the  large 
institutions.  Although  commissions  charged  for  issuing  travelers' 
letters  of  credit  vary  rather  widely,  i  per  cent  is  a  fairly  common 
rate. 

Sometimes  the  letter  of  credit  is  addressed  to  only  one  bank, 
in  which  case  it  is  referred  to  as  a  "specially  advised"  credit. 


V]  LETTERS  OF  CREDIT  79 

Such  credits  are  issued  when  the  traveler  expects  to  spend  most  of 
his  time  abroad  at  one  place.  A  "clean  credit"  is  sometimes  opened 
(usually  by  cable)  at  a  designated  foreign  bank  in  favor  of  the 
traveler.  This  latter  form  of  credit  does  not  require  the  use  of  the 
letter  of  credit  instrument;  it  is  very  similar  to  a  deposit  account 
opened  in  a  foreign  bank. 

References 

Commercial  Paper  and  Bills  of  Exchange  of  the  World. 

Facsimiles  of  forms,  pp.  19-35. 
Duncan,  C.  S.     Marketing,  Its  Problems  and  Methods. 

On  financing  distribution,  pp.  248-273. 
Filsinger,  E.  B.     Trading  with  Latin  America,     pp.  134-163. 
Guaranty  Trust  Company,  New  York.     How  Business  with   Foreign 

Countries  Is  Financed,     pp.  30-31,  44-48. 
Holdsworth,  J.  T.     Money  and  Banking. 

Letters  of  credit,  pp.  248-251. 
Hough,  B.  O.     Elementary  Lessons  in  Exporting. 

Forms,  p.  120. 
Moulton,  H.  G.     Financial  Organization  of  Society,     pp.  414-417. 
O'Mally.F.O.     Our  South  American  Trade  and  Its  Financing.     Published 

by  National  City  Bank.     pp.  42-58. 
Westerfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  V,  pp.  1244- 

1263. 
Willis, H.  P.,  and  Edwards,  G.  W.     Banking  and  Business,     pp.  276-279. 


CHAPTER  VI 
NEGOTIABILITY 

1.  Meaning  of  Negotiability. — Because  of  the  particular  ser- 
vices which  certain  credit  instruments  render  in  commercial 
transactions,  special  attributes  or  qualities  have  been  assigned  to 
them  by  the  earlier  law  of  merchants  and  by  common  and  statu- 
tory law.  Negotiability  is  a  legal  attribute  possessed  by  certain 
written  contractual  obligations,  and  means  the  quality  of  trans- 
ferability or  salability  which  gives  to  the  bona  fide  holder  for 
value  exceptional  rights  and  facilities  to  enforce  payment.  The 
transfer  of  title  is  effected  in  the  simplest  manner,  either  by  in- 
dorsement or  by  mere  delivery,  provided,  of  course,  value  is  given; 
"to  negotiate  a  bill  of  exchange,"  therefore,  can  only  mean  to 
transfer  it  for  value.  It  is  often  stated  that  a  negotiable  instru- 
ment confers  upon  the  bona  fide  holder  a  right  of  action  in  his  own 
name.  This  is  a  faulty  definition  because  in  many  cases  it  is  not 
true.  Foreign  government  bonds  are  universally  acknowledged 
as  negotiable  securities,  yet  the  holder  cannot  sue  the  foreign 
government  for  their  payment  if  in  default;  neither  can  the  holder 
bring  a  maintainable  action  against  the  bank  or  house  which 
issued  such  bonds  in  behalf  of  the  foreign  government.  In  short, 
it  is  against  the  comity  of  nations  and  international  policy  to 
entertain  an  action  by  an  individual  against  another  state.  And 
in  our  own  country  no  person  can  of  his  own  accord  bring  suit 
against  any  state  or  the  national  government  to  recover  on  state 
or  federal  bonds. 

2.  Historical  Significance. — To  throv/  light  upon  the  historical 
significance  of  negotiability,  it  is  helpful  to  consider  briefly  certain 
aspects  of  the  development  of  the  law  of  merchants.    The  "law 

80 


VI]  NEGOTIABILITY  8 1 

merchant,"  or  '4a\v  of  merchants,"  refers  to  a  body  of  rules  de- 
duced from  customs  and  usages  general  among  medieval  mer- 
chants, and  regulating  matters  peculiar  to  their  dealings,  such  as 
commercial  paper,  exchange,  sale  and  transportation  of  goods. 
In  the  medieval  markets  trade  customs  were  established  outside 
national  and  territorial  law  by  the  necessity  of  the  case.  At  the 
time  when  trading  began,  all  foreigners  were  presumed  to  be 
enemies.  Nevertheless,  a  system  of  silent  barter,  then  of  mar- 
kets, and  later  a  special  peace  of  markets  and  hospitality  for 
foreign  merchants  grew  up  without  any  sanction  other  than  con- 
venience. The  summary  practice  which  developed  in  these 
markets  did  not  rest  exclusively  on  the  positive  institutions  and 
local  customs  of  any  particular  country  but  consisted  of  certain 
principles  of  equity  and  usages  of  trade  which  general  convenience 
and  a  common  sense  of  justice  established  to  regulate  the  affairs 
of  merchants  and  mariners  in  all  the  commercial  countries  of  the 
civilized  world. 

There  is  no  reason  to  suppose  that  merchants  first  sought  the 
aid  of  the  regular  courts  and  were  refused;  the  formal  procedure, 
repeated  summons,  and  laws  of  various  local  bodies,  were  plainly 
too  slow  and  unsuited  for  them.  In  England,  for  example,  the 
attributes  of  a  bill  payable  "to  order"  or  "to  bearer"  were  in- 
compatible with  the  legal  details  required  for  the  transfer  of 
property  and  the  carrying  out  of  other  forms  of  contracts.  As  a 
means  of  settling  payments  at  the  great  fairs  and  market  places 
of  the  Middle  Ages  there  was  needed  an  instrument  which  in  the 
hands  of  an  innocent  third  party  should  be  free  from  personal 
defenses  and  equities  of  prior  parties.  In  the  dealings  between 
merchants  many  irregularities  were  bound  to  arise,  and  if  a  third 
party  were  asked  to  accept  an  instrument  whose  ownership  might 
later  be  subject  to  litigation  he  would  ordinarily  refuse,  because  of 
the  risks  involved.  Moreover,  in  a  period  when  even  domestic 
travel  was  fraught  with  many  dangers  and  the  transportation  of 
actual  money  for  making  purchases  or  settling  debts  was  a  very 


82  BANKING  AND  CREDIT  [VI 

risky  undertaking,  it  is  not  surprising  that  out  of  the  need  should 
arise  mere  pieces  of  paper  possessing  by  common  usage  special 
attributes  of  salability. 

3.  Negotiable  Instruments. — Commercial  paper,  including 
bills  of  exchange,  notes,  warehouse  receipts,  order  bills  of  lading, 
warrants  calling  for  the  delivery  of  goods  or  money,  and  many 
other  documents  when  properly  drawn  are  negotiable;  but,  of 
course,  the  actual  goods  covered  by  these  instruments  are  not 
negotiable.  Money  possesses  negotiability  in  the  fullest  sense. 
A  person  wrongfully  in  the  possession  of  money  may  transfer  it 
to  another  in  payment  for  goods  or  services,  and  this  second  per- 
son will  have  perfect  legal  right  to  it,  provided  he  has  acted  in 
good  faith.  This  is  to  be  contrasted  with  a  non-negotiable  article, 
such  as  an  automobile.  The  innocent  purchaser  of  a  stolen  car 
does  not  obtain  legal  title  to  it,  and  it  can  be  recovered  by  the 
person  from  whom  it  was  stolen,  whose  title  is  not  affected  by  the 
theft.  Similarly,  in  the  case  of  a  non-negotiable  instrument,  the 
purchaser  receives  it  subject  to  all  its  original  defenses  and  should 
protect  himself  by  an  investigation  of  its  origin  and  history. 

4.  Purpose  Served  by  Negotiability. — The  attribute  of  nego- 
tiability is  thus  given  to  certain  instruments  of  exchange  in  order 
to  facilitate  business  transactions.  Two  somewhat  contrasting 
interests  must  be  served.  On  the  one  hand,  the  financial  machin- 
ery of  trade  must  be  provided  with  all  the  equipment  necessary 
to  work  quickly  and  without  interruptions  on  account  of  defects 
in  any  of  the  parts.  For  this  reason  negotiability  is  a  quality 
which  commercial  paper  must  possess  in  order  to  circulate  freely 
and  to  perform  the  greatest  possible  service.  Otherwise  a  banker 
or  note-broker  buying  in  good  faith  a  bill  of  exchange  or  note 
would  have  to  determine  whether  a  consideration  was  given  by 
every  prior  holder,  or  whether  a  counter-claim  against  some  prior 
party  or  a  fraudulent  act  occurred  somewhere  in  its  history, 


VI]  NEGOTIABILITY  83 

thereby  nullifying  his  right  to  enforce  payment.  On  the  other 
hand,  the  property  rights  of  all  the  individuals  involved  must  be 
given  adequate  protection  consistent  with  the  wider  needs  of 
business  society. 

Under  certain  conditions  the  holder  of  a  negotiable  instrument 
may  have  more  rights  than  those  possessed  by  the  person  from 
whom  it  was  received.  For  example,  the  First  National  Bank 
has  purchased  in  good  faith  from  Robert  Moseley  a  promissory 
note  made  out  to  him  as  payee  by  Andrew  Arnold.  It  sub- 
sequently develops  that  the  instrument  contains  a  legal  defect 
known  as  "failure  of  consideration,"  occasioned  by  the  non- 
delivery of  some  chemicals  purchased  by  Arnold  from  Moseley. 
Moseley  could  not  have  collected  on  it  because  of  Arnold's  legal 
defense  of  failure  of  consideration,  but  the  bank  as  an  innocent 
purchaser,  unaware  of  this  defect,  can  enforce  payment  by 
Arnold. 

5.  Requirements  of  Attribute. — Any  instrument  to  be  negoti- 
able in  the  highest  degree  must  conform  to  the  following  re- 
quirements: 

1.  It  must  be  in  writing  (includes  print  and  pencil-writing) 
and  signed  by  the  maker  or  drawer. 

2.  It  must  contain  an  unconditional  promise  or  order  to  pay 
a  sum  certain  in  money. 

3.  It  must  be  payable  on  demand  or  at  a  fixed  or  determinable 
future  time. 

4.  It  must  be  payable  to  order  or  to  bearer. 

5.  Where  an  instrument  is  addressed  to  a  drawee,  as  in  the 
case  of  a  bill  of  exchange,  this  person  must  be  named  or  otherwise 
indicated  with  reasonable  certainty. 

6.  Uniform  Negotiable  Instruments  Law. — A  uniform  nego- 
tiable instruments  law  has  been  adopted  with  little  variation  by 
the  majority  of  the  states.    It  is  a  codification  of  the  common  law 


84  BANKING  AND  CREDIT  [VI 

and  the  law  merchant  appHcable  to  bills  and  notes.  Its  object  is 
to  make  this  important  branch  of  law  uniform  throughout  the 
United  States.  Although  several  of  the  states  have  made  certain 
statutory  changes  in  enacting  it,  the  changes  are  for  the  most 
part  of  minor  importance  and  it  may  be  said  that  the  law  of  bills 
and  notes  is  now  practically  uniform  in  this  country.  The  ma- 
terial in  this  chapter  follows  closely  the  Negotiable  Instruments 
Act  of  New  York. 

7.  Indorsement— How  Made. — The  indorsement  must  be 
written  on  the  instrument  itself  or  upon  a  paper  attached  thereto, 
called  an  "allonge."  The  signature  of  the  indorser  without  addi- 
tional words  is  sufficient.  Rubber  stamps  are- very  commonly 
used,  and  such  indorsements  are  usually  valid  except  in  locali- 
ties where  clearing-house  rules  forbid;  but  a  stamp  indorsement 
has  the  disadvantage  of  being  more  difficult  to  prove  authentic 
than  one  in  handwriting.  An  indorsement  written  in  pencil  is 
valid,  though  not  desirable.  When  the  payee  of  an  instrument, 
such  as  a  check,  indorses  by  mark  (X)  and  his  signature  is  wit- 
nessed, the  witness's  signature  is  considered  a  warranty  of  the 
genuineness  of  the  payee's  indorsement,  just  as  a  subsequent 
indorser  warrants  the  genuineness  of  the  signature  of  each  prior 
indorser. 

The  indorsement  must  cover  the  entire  instrument.  An  in- 
dorsement which  purports  to  transfer  to  the  indorsee  a  part  only 
of  the  amount  payable,  or  which  purports  to  transfer  the  instru- 
ment to  two  or  more  indorsees  severally,  does  not  operate  as  a 
negotiation.  But  if  the  instrument  has  been  paid  in  part  it  may 
be  indorsed  as  to  the  remainder. 

8.  Blank  Indorsement. — There  are  several  different  kinds  of 
indorsements.  These  will  be  first  described,  followed  by  specific 
examples.  An  indorsement  may  be  either  special  or  in  blank,  and 
it  may  also  be  either  restrictive,  qualified,  or  conditional.    A 


VI 


NEGOTIABILITY  85 


special  indorsement  specifies  the  person  to  whose  order  the  instru- 
ment is  payable;  and  the  indorsement  of  this  person  is  necessary 
to  the  further  negotiation  of  the  instrument. 

An  indorsement  in  blank  consists  simply  of  the  signature  of 
the  indorser  and  specifies  no  indorsee.  An  instrument  so  in- 
dorsed is  payable  to  bearer  and  may  be  negotiated  by  delivery 
without  requiring  indorsement  by  each  successive  holder.  The 
holder  may  convert  a  blank  indorsement  into  a  special  indorse- 
ment by  writing  "  Pay  to  [his  name]  "  over  the  blank  indorsement. 

9.  Restrictive  Indorsement. — A  restrictive  indorsement  is  one 
which : 

1.  Prohibits  the  further  negotiation  of  the  instrument. 

2.  Constitutes  the  indorsee  the  agent  of  the  indorser. 

3.  Vests  the  title  in  the  indorsee  in  trust  for  or  to  the  use  of 

some  other  person. 

The  weight  of  authority  is  to  the  effect  that  an  indorsement, 
"for  deposit  to  the  credit  of"  the  depositor,  is  restrictive.  A 
restrictive  indorsement  confers  upon  the  indorsee  the  right: 

1.  To  receive  payment  of  the  instrument. 

2.  To  bring  any  action  thereon  that  the  indorser  could  bring. 

3.  To  transfer  his  rights  as  such  indorsee,  where  the  form  of 

the  indorsements  authorizes  him  to  do  so. 

The  form  commonly  used  is  "Pay  to  C.  D.  for  collection. 
A.  B."     Another  form  is  "Pay  to  C.  D.  only.     A.  B." 

10.  Qualified  Indorsement. — A  qualified  indorsement  simply 
passes  title  without  making  the  indorser  liable  upon  the  paper, 
except  in  case  of  fraud  or  forgery.  It  may  be  made  by  adding  to 
the  indorser 's  signature  the  words  "without  recourse"  or  any 
phrase  of  similar  meaning.  Such  an  indorsement  does  not  impair 
the  negotiable  character  of  the  instrument,  nor  does  an  indorse- 
ment without  recourse  relieve  the  indorser  from  responsibility  in 


86  BANKING  AND  CREDIT  [VI 

case  of  fraud  or  forgery.  By  this  indorsement  the  indorser  war- 
rants that  the  instrument  is  genuine  and  in  all  respects  what  it 
purports  to  be.  "A  gave  his  note  for  $5,000  to  a  cattle  company, 
secured  by  a  chattel  mortgage  on  certain  cattle.  The  cattle 
company  indorsed  the  note  without  recourse  and  sold  the  note 
and  the  mortgage  to  a  bank.  The  note  and  the  mortgage  proved 
fraudulent,  there  being  no  such  cattle  as  described  in  the  mortgage. 
Opinion:  The  cattle  company  is  liable  to  the  bank,  as  there 
was  a  breach  of  implied  warranty  of  the  validity  of  the  thing 
sold."' 

11.  Conditional  Indorsement. — If  an  indorsement  is  condi- 
tional, a  party  required  to  make  payment  may  disregard  the  con- 
dition and  pay  the  indorsee  or  transferee,  whether  the  condition 
has  been  fulfilled  or  not.  However,  any  person  to  whom  an  in- 
strument is  so  indorsed  will  hold  it,  or  the  proceeds,  subject  to  the 
rights  of  the  person  indorsing  conditionally.  The  following  is  an 
example  of  a  conditional  indorsement :  "Pay  to  Henry  W.  Good- 
win or  order  on  completion  of  the  Tyler  Building.    R.  H.  Scott." 

12.  Rules  Concerning  Indorsement.— If  an  instrument  is 
drawn  payable  to  bearer  it  does  not  legally  require  indorsement. 
An  instrument  payable  to  the  order  of  two  or  more  payees  or 
indorsees  who  are  not  partners  must  be  indorsed  by  all,  unless 
the  one  indorsing  has  the  authority  to  indorse  for  the  others. 
"Where  a  check  payable  to  A  and  B,  who  are  not  partners,  is 
indorsed  '  A  and  B  per  A '  and  is  offered  for  deposit  to  the  credit 
of  A's  personal  account,  the  bank  before  accepting  the  deposit 
should  be  satisfied  that  B  has  authorized  A  to  make  such  indorse- 
ment. Where  A  and  B  are  partners,  the  general  rule  is  that  in  the 
case  of  a  trading  or  commercial  firm,  any  member  has  implied 
authority  to  indorse  and  transfer  paper  by  indorsement  in  the 


'  Paton,  Digest  of  Legal  Opinions,  p.  93. 


VI]  NEGOTIABILITY  87 

firm's  name,  and  such  transfer  may  be  made  to  himself.  Such 
authority  is  not  implied  in  the  case  of  a  non-trading  firm."^ 

An  instrument  drawn  or  indorsed  to  a  person  as  cashier  or 
other  fiscal  officer  of  a  bank  or  corporation  is  deemed  prima  facie 
to  be  payable  to  the  bank  or  corporation  of  which  he  is  such 
officer;  and  may  be  negotiated  by  either  the  indorsement  of  the 
bank  or  corporation  or  the  indorsement  of  the  officer. 

Negotiable  instruments  should  be  indorsed  precisely  as  they 
are  drawn.  If  an  instrument  is  drawn  to  the  order  of  T.  B. 
Macaulay  it  should  be  so  indorsed,  and  not  Thomas  B.  Macaulay. 
"A  check  was  drawn  to  the  order  of  Miss  F.  M.  Taylor  and  bore 
the  indorsement  of  F.  M.  Taylor.  Opinion:  The  indorsement  is 
in  proper  form  as  the  prefix  Miss  is  not  recognized  in  law  as  a  part 
of  the  payee's  name."-*  If  a  name  of  a  payee  or  indorsee  is 
wrongly  designated  or  misspelled  he  may  indorse  the  instrument 
as  therein  described,  adding,  if  he  thinks  fit,  his  proper  signature. 

An  accommodation  indorsement  is  made  when  a  person  in- 
dorses in  order  to  lend  his  credit  to  another  party  to  the  instru- 
ment. For  example,  A.  B.  Collins  wishes  to  borrow  money  at  a 
bank  and  asksD.  E.French  to  lend  his  credit.  Collins  makes  out 
a  promissory  note  payable  to  French's  order,  French  indorses  it  in 
blank,  and  Collins  then  has  it  discounted  at  the  bank.  French 
is  the  accommodation  indorser  and  the  instrument  is  called 
"accommodation  paper." 

13.  Illustrations  of  Various  Kinds  of  Indorsement. — 

I.  An  indorsement  in  blank: 

Henry  Clay 

makes  the  instrument  payable  to  bearer. 
2. 

Pay  to  the  order  of  John  C.  Calhoun 
Henry  Clay 

^  Paton,  Digest  of  Legal  Opinions,  p.  89. 
^  Ihid.,  p.  87. 


88  BANKING  AND  CREDIT  [VI 

restricts  the  payment  to  John  C.  Calhoun  or  order.  This  is  a 
much  safer  form  of  indorsement  than  the  indorsement  in  blank. 
If  the  instrument  should  be  lost  or  fall  into  wrongful  possession, 
payment  could  not  be  collected;  John  C.  Calhoun's  signature  is 
necessary  before  payment  can  be  made.  A  restricted  indorsement 
of  this  kind,  or  like  illustration  3,  is  desirable  when  checks  are 
sent  through  the  mail  for  deposit  in  a  bank  and  in  general  when 
negotiable  instruments  are  being  transferred  by  one  holder  to 
another  through  the  means  of  some  forwarding  agency. 
3- 

For  deposit  with  the  Hub  Trust  Company  to  the  credit  of 
Henry  Clay 

is  a  restrictive  indorsement.    Under  the  rules  of  certain  clearing 
houses  a  check  with  a  "for  deposit"  indorsement  is  not  payable 
through  the  clearing  house  unless  prior  indorsements  are  guaran- 
teed by  the  bank  of  deposit. 
4- 

Without  recourse 
Henry  Clay 

conveys  or  transfers  but  does  not  guarantee  the  title.  The  words 
"without  recourse"  mean  that  Henry  Clay  wishes  to  incur  no 
liability  as  an  indorser  but  wishes  simply  to  transfer  the  title. 

5- 

Pay  Daniel  Webster  only 
Henry  Clay 

restricts  payment  to  Daniel  Webster. 
6. 

Pay  to  the  order  of  Millard  Fillmore,  Treasurer  ABC 

Company 

Henry  Clay 

does  not  permit  the  personal  or  private  use  of  this  money  by 


VI  ]  NEGOTIABILITY  89 

Millard  Fillmore,  and  imposes  liability  upon  the  organization  of 
which  he  is  treasurer. 
7- 

Pay  to  the  order  of  Horace  Greeley  for  collection 
Henry  Clay 

has  the  same  effect  as  indorsement  6.  When  a  check  is  so  in- 
dorsed and  delivered  to  a  bank,  the  latter  receives  it  merely  as 
the  agent  of  the  indorser  for  the  purpose  indicated  and  the  title 
to  the  check  remains  in  the  indorser. 


Pay  to  the  order  of  Franklin  Pierce  for  account  of 

Andrew  Jackson 

Henry  Clay 

has  also  the  same  effect  as  indorsement  6. 


Prior  indorsements  guaranteed 
Oceanic  National  Bank 

is  a  form  of  indorsement  used  by  banks,  particularly  on  checks  for 
the  clearing  house.  It  guarantees  the  genuineness  of  prior  in- 
dorsements and  covers  imperfections  and  any  irregularities.  "A 
check  was  payable  to  Mrs.  John  Doe  and  was  indorsed  without 
authority  '  Mrs.  John  Doe  by  John  Doe.'  The  bank  which  cashed 
the  item  indorsed  '  all  prior  indorsements  guaranteed,'  the  drawee 
bank  paid  the  check  and  Mrs.  Doe  did  not  receive  the  money. 
Opinion:  '  All  prior  indorsements  guaranteed '  warrants  the  genu- 
ineness of  the  payee's  indorsement,  not  only  where  the  name  of 
the  payee  is  forged,  but  also  where  the  payee's  name  is  signed 
without  authority  by  another."'' 

14.  Acceptance. — Acceptance    is    the    signification    by    the 
drawee  of  his  assent  to  the  order  of  the  drawer.    When  present- 


••  Paton,  Digest  of  Legal  Opinions,  p.  go. 


90  BANKING  AND  CREDIT  [VI 

ment  for  acceptance  is  required,  the  objects  are:  (i)  to  fix  the  time 
when  the  bill  matures,  and  (2)  to  charge  the  drawer  and  indorser 
with  liability.  There  are  two  kinds  of  acceptance,  general  and 
qualified.  A  general  acceptance  binds  the  acceptor  to  carry  out 
the  order  of  the  drawer  without  qualification.  An  acceptance 
which  makes  payment  dependent  upon  any  condition  or  in  ex- 
press terms  varies  the  effect  of  the  bill  as  drawn,  is  called  a ' '  quali- 
fied" acceptance. 

A  bill  cannot  be  accepted  verbally.  The  acceptance  must  be 
in  writing  and  must  be  signed  by  the  drawee.  However,  an 
acceptance  by  telegraph  is  valid  if  properly  expressed.  An  ac- 
ceptance written  on  a  separate  piece  of  paper  is  valid,  but  binds 
the  acceptor  only  in  favor  of  a  person  to  whom  it  is  shown  and 
who,  on  the  faith  thereof,  has  received  the  instrument  for  value. 

When  a  bill  is  delivered  to  a  drawee  for  acceptance,  under  the 
negotiable  instruments  law  he  has  twenty-four  hours  to  decide 
whether  or  not  to  accept.  If  presentment  for  acceptance  is 
required,  the  holder  must  present  the  bill  for  acceptance  or  nego- 
tiate it  within  a  reasonable  time.  However,  there  is  no  fixed  rule 
as  to  what  constitutes  a  reasonable  time;  it  depends  upon  the 
circumstances  of  each  particular  case.  If  a  bill  of  exchange  is 
payable  at  the  drawee's  place  of  business  30  days  after  date, 
presentment  for  payment  at  maturity  is  sufficient;  but  if  payable 
30  days  after  sight,  presentment  for  acceptance  is  necessary  in 
order  to  determine  the  day  of  maturity. 

15.  Presentment  for  Payment. — Presentment  of  a  bill  of  ex- 
change or  a  note  for  payment  at  the  proper  time  is  necessary  to 
charge  persons  secondarily  liable,  that  is,  the  drawer  and  the 
indorsers.  In  most  of  the  states  days  of  grace  have  been  abol- 
ished. If  an  instrument  specifies  a  day  of  maturity  it  should 
be  presented  at  a  reasonable  hour  on  the  day  on  which  it  falls 
due.  When  an  instrument  matures  on  Saturday,  Sunday,  or  a 
holiday,  it  should  be  presented  for  payment  on  the  next  succeeding 


VI]  NEGOTIABILITY  91 

business  day.  A  demand  note  must  be  presented  within  a  reason- 
able time  after  its  issue.  Just  what  is  a  reasonable  time  depends 
upon  the  circumstances  of  each  particular  case.  At  the  option  of 
the  holder  a  demand  note  may  be  presented  before  1 2  o'clock 
noon  on  Saturday,  when  that  entire  day  is  not  a  holiday. 

A  check  is  not  intended  for  general  circulation  as  a  medium  of 
exchange  and  should  therefore  be  presented  promptly;  if  on  a 
local  bank  it  should  be  presented  during  banking  hours  on  the 
day  following  its  receipt.  Failure  to  present  a  check  within  a 
reasonable  time  discharges  the  drawer  to  the  extent  of  any  loss 
as  a  result  of  the  delay,  as,  for  example,  because  of  the  failure 
of  the  bank. 

16.  Liabilities  of  Parties. — The  maker  of  a  promissory  note 
engages  that  he  will  pay  it  according  to  its  terms  and  therefore 
assumes  the  primary  liability.  In  the  case  of  a  draft  or  bill  of 
exchange  the  drawer  agrees  that  if  the  instrument  be  dishonored 
he  will  pay  the  amount  called  for  to  the  holder  or  to  any  indorser 
who  may  be  required  to  pay  it.  The  acceptor  of  a  draft  or  bill  of 
exchange  assumes  primary  liability  and  agrees  that  he  will  pay 
it  according  to  the  tenor  of  his  acceptance.  Every  indorser  who 
indorses  without  qualification  engages  that  if  the  instrument  is 
dishonored  he  will  reimburse  the  holder,  or  any  subsequent  in- 
dorser who  may  be  compelled  to  make  payment.  With  respect 
to  one  another,  indorsers  are  liable  prima  facie  in  the  order  in 
which  they  indorse,  but  evidence  is  admissible  to  show  that  as 
between  themselves  they  may  have  agreed  to  be  liable  jointly  or 
otherwise. 

17.  Protest— Meaning  of. — The  term  "protest"  in  its  com- 
mercial usage  includes  all  the  steps  necessary  to  fix  the  liability 
of  the  drawer  or  the  indorsers  upon  the  dishonor  of  a  negotiable 
instrument.  In  the  strict  legal  sense  it  signifies  the  testimony 
before  a  notary  or  other  authorized  person  that  the  instrument 


92  BANKING  AND  CREDIT  [VI 

has  been  presented,  demand  for  acceptance  or  payment  made, 
such  demand  refused,  and  the  instrument  dishonored,  followed 
by  a  solemn  declaration  or  formal  "protest"  that  any  resulting 
loss  shall  be  borne  by  the  drawer  or  indorsers,  and  not  by  the 
holder.  Formal  protest,  as  distinguished  from  demand  and  notice 
of  dishonor,  is  not  required  to  hold  the  indorsers  if  the  instrument 
is  an  inland  bill  of  exchange.  An  inland  bill  of  exchange  is  one 
drawn  and  payable  in  the  same  state  even  if  the  payee  is  located 
in  another  state;  a  foreign  bill  of  exchange  is  an  instrument 
drawn  in  one  state  and  payable  in  another.  In  the  case  of  an 
inland  bill  of  exchange,  however,  protest  is  often  desirable  for 
better  protection.  It  enables  the  holder  to  obtain  a  convenient 
means  of  proving  dishonor  in  case  he  is  compelled  to  bring  suit 
on  the  paper;  the  notary's  certificate  of  protest  is  admitted  as 
prima  facie  evidence  and  obviates  the  necessity  of  calling  witnesses 
and  proving  dishonor  by  other  testimony. 

i8.  Protest  Fees. — Protest  fees,  which  are  fixed  by  statute 
and  include  a  certain  charge  for  the  formal  protest  and  a  certain 
charge  for  each  notice  of  dishonor,  are  added  to  the  amount  to  be 
paid  by  any  party  liable  on  the  instrument.  Interest  also  is 
added  from  the  time  the  instrument  became  due  until  the  drawer 
or  prior  party  makes  payment  to  the  holder.  Protest  itself  is 
ordinarily  indicated  on  the  bill  or  note  by  writing  in  brief  form 
some  such  statement  as  "Payment  demanded  and  refused  Janu- 
ary lo,  1922,  R.  O.  J.  Fees  $1.25."  This  means  that  on  the 
date  indicated  the  notary  whose  initials  are  written  made  due 
presentment  and  demand,  that  the  instrument  was  dishonored 
and  protested,  and  that  the  notary's  charges  are  $1.25.  The  not- 
ary may  at  any  subsequent  date  "extend  "  the  protest  by  making 
out  his  formal  certificate. 

19.  Requirements  of  Protest. — When  a  bill  is  protested,  such 
protest  must  be  made  on  the  day  of  its  dishonor,  unless  the  delay 


VI  ]  NEGOTIABILITY  93 

is  excused  as  provided  by  law  in  certain  circumstances.  A  bill 
must  be  protested  at  the  place  where  it  is  dishonored,  except  that 
when  a  bill  is  drawn  payable  at  the  place  of  business  or  residence 
of  some  person  other  than  the  drawee,  and  has  been  dishonored  by 
non-acceptance,  it  must  be  protested  for  non-payment  at  the 
place  where  it  is  expressed  to  be  payable  and  no  further  present- 
ment for  payment  to,  or  demand  on,  the  drawee  is  necessary. 

Usually  the  notary  gives  the  necessary  notice  of  dishonor  to 
the  drawer  or  indorsers,  but  this  may  be  done  by  the  holder  or  by 
any  agent  of  his.  When  the  notary  gives  such  notices  he  may 
include  a  statement  to  that  effect  in  his  certificate,  but  the  prac- 
tice in  this  matter  varies.  If  the  statement  that  notices  have  been 
duly  given  is  not  contained  in  the  certificate,  the  fact  would  have 
to  be  proved  at  a  trial  by  the  evidence  of  the  notary  or  other  per- 
son who  gave  them. 

In  some  cases  banks  and  other  holders  of  negotiable  instru- 
ments prefer  to  avoid  protest  fees  by  requesting  that  the  instru- 
ments are  not  to  be  protested  in  case  of  dishonor.  Instructions 
of  this  kind  are  usually  indicated  on  a  perforated  edge  of  the 
instrument  which  may  read  simply  "  No  protest."  If  the  instru- 
ment is  to  go  through  the  ordinary  channels  of  formal  protest  in 
case  of  dishonor  this  perforated  edge  is  detached. 

References 

Moulton,  H.  G.     Financial  Organization  of  Society. 

Negotiable  instruments,  pp.  172-184. 
Principles  of  Money  and  Banking. 

Extracts  from  Negotiable  Instruments  Law,  Part  II,  pp.  40-48. 

Legal    Works 

Brady,  J.  E.     The  Law  of  Bank  Checks. 
Huffcut,  E.  W.     The  Law  of  Negotiable  Instruments. 
Moore,  W.  U.     The  Law  of  Commercial  Paper. 

Schaub,  L.  F.,  and  Isaacs,  N.     The  Law  in  Business  Problems,     pp.  529- 
54Q- 


CHAPTER  VII 

BUSINESS  OF  BANKING 

I.  Historical  Development— Money-Changers.^In  the  de- 
velopment of  the  mechanism  of  exchange  which  has  been  de- 
scribed in  the  preceding  chapters,  a  distinct  branch  of  business, 
known  as  "banking,"  has  been  created.  This  embraces  a  great 
variety  of  operations.  In  some  of  its  practices  it  dates  from  an- 
tiquity. New  functions  have  been  added  to  meet  the  changing 
needs  of  commerce  and  industry.  At  one  period  the  emphasis 
has  been  to  facilitate  individual  transfers  of  credit;  at  another  to 
furnish  a  convenient  medium  of  exchange;  at  another  to  quicken 
the  operations  of  settlement  of  indebtedness  between  distant 
points;  at  another  to  provide  a  safe  place  for  the  keeping  of  funds; 
and  at  another  to  supply  credit  to  those  in  need  of  readily  avail- 
able capital. 

The  use  of  instruments  of  credit,  as  promissory  notes,  bills 
of  exchange,  and  transfer  checks,  was  known  several  centuries 
before  Christ.  As  trade  developed  between  different  countries, 
the  exchange  of  foreign  moneys  became  a  specialized  trade. 
Assyria,  Babylonia,  Greece,  and  Rome  were  familiar  with  money- 
changers. In  Rome  money-changers  also  accepted  money  for 
deposit,  loaned  money,  and  dealt  in  foreign  bills  of  exchange.  A 
special  body  of  law  was  developed  relating  to  these  subjects.  The 
downfall  of  Rome,  followed  by  the  Dark  Ages,  with  insecurity  of 
property  and  lessening  of  commercial  enterprise,  checked  the 
growth  of  these  operations.  By  the  eleventh  century  Italy  en- 
joyed a  restoration  of  social  order  and  commercial  stability,  and 
the  simpler  operations  of  the  banking  business,  referred  to  above, 
again  became  an  important  occupation,  largely  in  the  hands  of  the 
Jews  and  the  Lombards. 

94 


VII J  BUSINEvSS  OF  BANKING  95 

2.  Rise  of  the  Bank. — The  next  step  was  to  organize  this  pri- 
vate occupation  into  more  powerful  associations.  ''The  in- 
divickial  money-changer,  the  Jewish  lender,  the  Lombard  banker, 
gradually  gave  way,  as  centralization  advanced  in  commerce  and 
in  national  life,  to  public  banks  doing  business  under  official 
authority."'  Public  banks  were  estabHshed  in  Venice  (1587)  and 
Amsterdam  ( 1 609) .  These  banks  were  more  concerned  in  provid- 
ing a  convenient  currency,  aiding  governments  by  loans,  and 
assisting  in  settlement  of  indebtedness,  than  in  organizing  and 
supplying  credit.  The  creation  of  credit  through  the  issue  of  the 
bank's  promissory  notes  based  upon  public  confidence  rather 
than  upon  a  metallic  reserve  has  been  largely  an  evolution  of  a 
more  recent  period.  And  the  past  century  has  witnessed  a  special- 
ization of  all  these  varied  activities — money-changing,  foreign 
exchange,  care  of  deposits,  advance  of  credit,  and  the  creation  of 
currency  with  wide  acceptability — so  that  now  there  are  many 
different  kinds  of  banking  institutions,  some  exercising  only 
one  or  two  of  these  functions,  and  some  covering  the  entire 
range. 

3.  Definition  of  a  Bank. — As  a  result  of  these  changes,  it  is 
difficult  to  define  the  term  "bank"  precisely.  Many  definitions 
have  been  given.  Dunbar  describes  it  as  an  "establishment 
which  makes  to  individuals  such  advances  of  money  or  other 
means  of  payment  as  may  be  required  and  safely  made,  and  to 
which  individuals  entrust  money  or  other  means  of  payment, 
when  not  required  by  them  for  use.  In  other  words,  the  business 
of  a  bank  is  said  to  be  to  lend  or  discount,  and  to  hold  deposits. 
With  these  two  functions  may  be  combined  a  third,  that  of  issu- 
ing bank  notes,  or  the  bank's  own  promises  to  pay,  for  use  in 
general  circulation  as  a  substitute  for  money. "^ 

According  to  Johnson,  "A  bank  is  an  institution  which  deals 


'  C.  A.  Conant,  The  Principles  of  Money  and  Banking,  Vol.  II,  p.  176. 
-  C.  F.  Dunbar,  Theory  and  History  of  Banking,  p.  9. 


96  BANKING  AND  CREDIT  [  VII 

in  credit."-^  A  similar  definition  is  that  recently  given  by  an 
American  banker:  "A  great  many  people  think  of  a  bank  as  a 
place  to  put  away  money  and  when  they  want  it  to  go  and  get  it 
again — but  that  is  not  a  bank — that  is  a  safe  deposit  box.  A 
bank  is  a  manufacturer  of  and  a  dealer  in  credit."''  Conant  puts 
the  emphasis  on  the  service  which  banking  furnishes  in  making 
easy  the  exchange  of  goods.  "The  function  of  the  banker  lies  in 
economizing  the  use  of  money,  and  thereby  in  further  diminishing 
the  cost  and  effort  of  exchange. "^ 

In  brief,  banking  institutions  are  concerned  with  the  business 
of  making  loans,  receiving  and  investing  deposits,  and  effecting 
the  transfer  of  credits  from  one  person  to  another.  To  carry  out 
these  objects,  other  functions  may  be  exercised  by  a  bank  as  in  the 
issue  of  bank  notes,  in  order  to  enlarge  its  own  credit. 

4.  Classification  of  Banks— According  to  Function. — Accord- 
ing as  the  emphasis  is  laid  upon  a  particular  activity  or  function, 
banks  in  the  United  States  may  be  classified  as: 

1.  Commercial  banks,  which  are  engaged  in  making  loans 

to  business  establishments,  receiving  deposits  against 
which  checks  may  be  freely  drawn,  transacting  ex- 
change operations,  and  making  collections  on  commer- 
cial paper  which  becomes  due. 

2.  Savings  banks,  for  the  care  and  investment  of  deposits — 

the  service  to  the  depositor  and  the  security  of  the 
deposit  being  the  first  object. 

3.  Trust  companies,  which  were  originally  organized  for  the 

care  of  estates  or  property  held  in  trust. 

Many  of  these  last-named  institutions  now  possess  attributes 
of  commercial  banks  on  the  one  hand  and  of  savings  banks  on  the 


i  J.  F.  Johnson,  Money  and  Currency,  p.  44. 

'•  David  R.  Forgan  in  Bankers'  Magazine.  June  1920,  p.  977. 

S  C.  A.  Conant,  The  Principles  of  Money  and  Banking,  Vol.  II,  p.  20O. 


VII  ]  BUSINESS  OF  BANKi/nG  97 

Other.  Owing  to  the  extension  of  this  activity  the  term  ''trust 
company,"  as  distinguished  from  a  bank,  has  Kttle  significance  in 
some  states. 

Other  institutions  besides  those  named  may  do  some  form  of 
banking  business,  as:  Express  companies  deal  in  exchange  and 
issue  money-orders;  mortgage  investment  companies  make  loans 
on  real  estate;  investment  houses  underwrite  loans  to  large  cor- 
porations; building  and  loan  associations  and  co-operative  banks 
make  loans  to  members  for  building;  private  bankers  make  loans 
and  receive  deposits;  note-brokers  act  as  agents  in  placing  short- 
term  loans  for  business  men  and  corporations;  and  even  the 
government,  through  the  post-ofhce,  assists  in  the  work  of  trans- 
ferring money  by  the  issue  of  money-orders,  and  receives  savings 
deposits.  Some  of  the  larger  insurance  companies,  by  reason  of 
the  constant  stream  of  cash  received  from  pohcy-holders,  find 
it  advantageous  to  engage  in  banking  operations,  not  only  by 
investment  in  securities  but  by  discount  of  short-time  paper. 

One  writer  has  observed  that  "  the  savings  bank  is  usually  the 
bank  of  the  small  depositor,  the  wage-earner,  and  the  thrifty  of 
all  classes;  the  trust  company  gives  its  services  more  especially  to 
those  who  have  fixed  incomes  from  investments,  landowners,  and 
corporations.  The  commercial  bank  does  business  with  manufac- 
turers, tradesmen,  merchants  and  others  who  'turn'  their  money 
at  seasonal  intervals."^  But  the  different  classes  of  banking  institu- 
tions so  blend  into  each  other  in  the  services  which  they  render 
that  in  some  sections  the  choice  of  a  bank,  whether  it  be  called  a 
"national"  bank,  a  "state"  bank,  a  "savings"  bank,  or  a  "trust 
company,"  is  a  matter  of  indifference.  Many  national  banks, 
state  banks,  and  trust  companies  have  savings  departments  de- 
signed to  meet  the  needs  of  the  small  depositor;  and  many  so- 
called  savings  banks  engage  in  commercial  banking  by  supplying 
credit  facilities  to  the  manufacturer  and  merchant. 


*  O.  H.  Wolfe,  Elementary  Banking,  p.  17. 
7 


98  BANKING  AND  CREDIT  [VII 

5.  Source  of  Charter. — Banks  are  also  classified,  according  to 
the  source  of  charter,  as: 

1 .  Federal,  that  is,  organized  under  federal  law,  for  example, 

the  old  First  United  States  Bank,  1791-1811;  the  Sec- 
ond United  States  Bank,  1816-1836;  national  banks, 
dating  from  1863 ;  and  federal  reserve  banks  established 
in  1914. 

2.  State  banks,  organized  under  state  laws. 

3.  Private  banks  which  do  not  have  any  banking  charter. 

According  to  the  formal  classification  of  banking  institutions 
adopted  by  the  Comptroller  of  the  Currency  in  his  annual  review 
of  banking  operations,  the  following  types  of  banks  are  to  be 
noted:  national  banks,  state  banks,  loan  and  trust  companies, 
mutual  savings  banks,  stock  savings  banks,  United  States  postal 
system,  private  banks,  federal  reserve  banks,  federal  farm  loan 
banks,  and  building  and  loan  associations.  As  stated  above,  these 
names  in  some  cases  have  little  significance  as  an  index  of  the  kind 
of  business  performed,  but  the  classification  is  useful  in  making  a 
general  survey  of  the  banking  business. 

6.  Commercial  Banking. — There  is  a  further  distinction — that 
between  commercial  banking  and  financial  banking.  By  "com- 
mercial banking"  is  meant  the  use  of  short-term  credit  to  aid  in 
the  production  and  marketing  of  commodities.  "  Financial  bank- 
ing" applies  the  resources  of  credit  to  fixed  forms  of  investment, 
as  in  stocks  and  bonds.  With  the  rapid  increase  in  the  volume  of 
securities  during  the  past  twenty  years,  and  the  opportunities  for 
favorable  speculative  investment,  there  has  been  a  great  tempta- 
tion for  banks  to  use  their  resources  in  the  purchase  of  securities 
for  the  profits  to  be  gained  by  advance  in  price.  Banks  which 
follow  this  policy  tend  to  become  investment  or  finance  compan- 
ies, although  they  are  still  known  as  banks. 

It  is  the  practice  of  most  commercial  banks  not  to  deal  with 


VII 1  BUSINESS  OF  BANKING  99 

undertakings  which  are  in  the  promotion  stage,  and  to  refuse  to 
become  interested  in  them  until  they  have  demonstrated  through 
operation  a  successful  earning  power  and  can  render  a  statement 
showing  a  satisfactory  relation  between  current  assets  and  current 
liabilities.  There  are  good  reasons  why  commercial  banks  must 
restrict  their  functions  to  that  of  short-term  loans  and  credits  to 
business  men  for  current  operating  needs:  the  fact  that  most 
of  the  depositors  have  the  right  to  demand  funds  at  any  time  and 
that  the  other  depositors  are  entitled  to  withdraw  their  money  at 
short  notice  requires  that  the  principal  assets  be  of  a  liquid  char- 
acter— such  as  can  be  readily  realized  upon  in  case  of  need.  If 
commercial  bankers  fail  to  observe  this  primary  principle  and 
involve  themselves  in  one  way  or  another  in  transactions  involv- 
ing promotions  of  enterprises  or  in  large  investments  in  stocks  and 
bonds,  difficulties  very  often  follow. 

Nor  can  a  large  commercial  bank  advantageously  associate 
itself  too  intimately  with  the  financing  of  a  business  concern. 
This  intimate  relationship  may  induce  the  latter's  competitors  to 
secure  banking  accommodations  elsewhere.  The  mere  fact  that 
an  official  of  a  certain  bank  is  a  director  in  some  manufacturing 
plant  may  cause  competing  manufacturers  to  refuse  to  carry  their 
accounts  in  this  bank  because  of  fear  of  divulging  trade  informa- 
tion. To  be  sure,  if  the  enterprise  in  question  is  substantially  a 
monopoly  in  that  particular  district  the  situation  is  quite  differ- 
ent. Many  smaller  commercial  banks,  however,  are  established 
primarily  for  meeting  the  needs  of  special  businesses,  such  as  a 
shoe  or  leather  plant.  In  these  instances  the  principal  officers  of 
the  bank  are  usually  the  principal  officers  of  the  manufacturing 
company  and  the  financial  problems  of  one  activity  merge  with 
those  of  the  other. 

Commercial  banks  can  in  effect  and  frequently  do  advance 
funds  for  long-term  periods  by  renewals  of  loans  or  by  allowing 
demand  notes  to  run  for  long  periods.  It  is  not  to  be  assumed, 
however,  that  from  the  viewpoint  of  banking  principles  this 


100  BANKING  AND  CREDIT  [  VII 

policy  is  at  all  equivalent  to  the  purchase  of  a  company's  securi- 
ties or  long-term  obligations.  On  the  contrary,  the  bank  is  always 
in  a  position  readily  to  liquidate  its  loan  if  need  arises,  by  refusing 
to  renew  it  at  maturity  or  by  calling  for  immediate  payment  in 
the  case  of  a  demand  note. 

7.  Investment  Bankers. — The  fixed  capital  requirements  of 
an  enterprise,  such  as  for  the  purpose  of  purchasing  equipment  or 
enlarging  the  plant,  must  as  a  general  thing  be  taken  care  of  else- 
where tTian  through  the  medium  of  a  commercial  bank.  Gener- 
ally speaking,  business  firms  are  not  equipped  for  this  kind  of 
work  because  of  its  very  nature.  The  necessity  for  it  arises  only 
at  long  intervals  in  the  life  of  an  ordinary  establishment,  but  when 
that  happens  the  professional  services  of  a  specialist  and  his 
ability  to  analyze  market  conditions  for  securities  makes  him  an 
indispensable  factor  in  the  project.  There  is  a  special  class  of 
bankers  who  provide  the  channels  through  which  concerns  can 
raise  these  new  funds  for  capital  investment,  and  a  large  part  of 
this  credit  is  supplied  by  bond  houses.  Bankers  who  handle  this 
kind  of  business  are  termed  ''investment  bankers"  to  distinguish 
them  from  ''commercial  bankers,"  who  are  engaged  primarily  in 
supplying  their  customers  with  funds  for  a  period  ranging  from  30 
days  up  to  6  months.  In  recent  years  there  has  been  a  growing 
tendency,  particularly  among  trust  companies,  to  establish  invest- 
ment or  bond  departments  to  carry  on  some  of  the  activities  of 
investment  banking.  Very  often  the  terms  "private  bankers" 
and  "banking  houses"  are  used  synonymously  with  "investment 
bankers."  Such  banking  institutions  can  properly  be  designated 
as  "private  bankers,"  partly  because  their  dealings  with  the  pub- 
lic are  much  more  limited  than  are  the  dealings  of  commercial 
banks  and  savings  banks,  and  partly  because  they  are  frequently 
not  incorporated  but  do  business  as  individuals  or  partnerships. 

A  successful  investment  banker  must  be  constantly  in  touch 
with  the  present  market  requirements  for  different  classes  of 


VIII  BUSINESS  OF  BANKING  lOI 

stocks  and  bonds,  and  must  also  be  able  to  foresee  with  reasonable 
certainty  any  changes  in  the  near  future.  Are  interest  rates  at 
the  moment  temporarily  high?  If  so,  notes  running  for  6  months 
or  possibly  for  one  or  two  years  should  be  issued  rather  than  a 
long-term  bond.  Similarly,  if  the  market  is  speculatively  in- 
clined and  security  prices  are  advancing,  the  time  may  be  ripe  for 
an  issue  of  stock  instead  of  bonds. 

Ultimately  the  decision  of  the  investment  banker  with  regard 
to  a  new  offering  of  stock  or  bonds  will  depend  upon  the  require- 
ments of  the  customers  to  whom  he  expects  to  resell  the  securities. 
The  promoter  or  corporation  official  who  goes  to  the  "  Street "  for 
funds  and  is  refused,  very  often  feels  that  he  has  been  discrimi- 
nated against  and  that  he  is  the  victim  of  a  money  trust.  In 
reality  in  most  such  instances  the  paper  which  has  been  offered  is 
of  such  character  that  it  possesses  little  if  any  marketability. 
The  position  of  the  investment  banker  is  then  very  much  like 
that  of  the  merchant.  The  merchant  receives  many  requests 
from  salesmen  to  buy  different  kinds  of  merchandise,  but  his  selec- 
tions must  conform  to  the  requirements  of  his  customers.  The 
analogy  between  the  merchant  and  the  investment  banker  is 
further  illustrated  in  the  case  of  old  business  houses  which  are 
widely  known.  Just  as  their  products  require  little  advertising 
by  the  merchant,  their  securities  require  little  advertising  by  the 
banker. 

References 

Holdsworth,  J.  T.     Money  and  Banking,     pp.  151-161. 

Westerfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  I,  pp.  iSo-iqo. 

Willis,  H.  P.,  and  Edwards,  G.  W.     Banking  and  Business,     pp.  46-56. 


CHAPTER  VIII 

VARIOUS    KINDS    OF    BANKING    AND     CREDIT 
INSTITUTIONS 

I.  Origin  of  National  Banking  System. — When  the  Civil  War 
broke  out,  all  incorporated  banks  were  organized  under  state 
charters.  Congress  had  refused  thirty  years  previously,  in  Jack- 
son's administration,  to  renew  the  charter  of  the  Second  United 
States  Bank  and  the  system  of  state  banks  operating  under  state 
charters,  which  had  already  grown  up  side  by  side  with  the  First 
United  States  Bank  (1791-1811)  and  its  successor,  the  Second 
United  States  Bank  (1816-1836),  took  entire  possession  of  the 
banking  field.  There  was  little  demand  for  attempting  a  third 
experiment  in  a  centralized  institution. 

The  Civil  War  introduced  new  credit  and  financial  tasks 
which  the  state  banks  were  not  prepared  to  perform  adequately. 
The  government  would  not  accept  state  bank  notes  in  payment 
for  the  national  loans  put  out  in  1861 ,  and  the  banks  were  unable 
to  pay  gold.  As  a  result  both  the  banks  and  the  government 
suspended  specie  payments.  Moreover,  in  a  time  of  war  the 
government  is  obliged  to  turn  to  banking  institutions  for  immedi- 
ate help;  the  revenue  supports  are  not  sufficient.  Not  only  are 
banks  called  upon  for  loans  on  account  of  their  organized  credit 
machinery  but  they  have  the  equipment  for  prompt  service  in 
connection  with  popular  loans.  State  banks  operating  under 
different  state  statutory  requirements  and  grants  of  power  can- 
not be  quickly  organized  into  an  effective  agency  for  national  aid. 
Such  was  the  condition  at  the  outbreak  of  the  Civil  War.  It  was 
also  believed  that  a  more  stable  market  for  government  securities 
could  be  established  by  basing  bank  note  circulation  upon  owner- 
ship and  pledge  of  United  States  bonds.    Much  of  the  currency 


VIII  ]  BANKING  AND  CREDIT  INSTITUTIONvS  103 

issued  by  state  banks  was  in  an  unsatisfactory  condition  and  was 
regarded  with  suspicion. 

Congress,  therefore,  determined  to  create  a  new  national  sys- 
tem, retaining,  however,  the  principle  of  local  independent  banks 
instead  of  the  establishment  of  one  large  powerful  centralized 
institution.  By  creating  a  widespread  system  of  banks  operating 
under  similar  charters  uniform  throughout  the  country,  it  was 
hoped  to  establish  an  agency  of  financial  support  to  the  govern- 
ment as  well  as  to  increase  public  confidence  in  the  currency. 

2.  National  Banking  Act  of  1863. — There  were  three  distinc- 
tive features  in  the  National  Banking  Act  passed  in  1863  in  its 
application  to  the  functions  of  the  banks  organized  under  federal 
authority.    These  were: 

1.  Responsibility  to  federal  authority  in  organization,  ex- 

amination, and  supervision. 

2.  Provision  for  a  uniform  currency  based  upon  pledge  and 

security  of  United  States  bonds  previously  purchased. 

3.  Maintenance  by  each  bank  of  certain  definite  reserves. 

The  act  provided  that  a  national  bank  could  be  formed  under 
permission  of  the  Comptroller  of  the  Currency  by  any  number  of 
persons,  not  less  than  five;  that  the  minimum  capital  should  be 
$50,000  in  places  of  not  over  6,000  inhabitants,  and  a  required 
capitalization  of  $200,000  in  places  of  over  50,000.  The  capital 
stock  must  be  paid  in.  The  charter  was  to  run  for  twenty  years. 
Stockholders  were  liable  for  the  amount  of  their  shares  and  in 
addition  to  an  equal  amount.  United  States  bonds  were  to  be 
purchased  in  proportion  to  the  capital.  Bank  notes  were  to  be 
issued  upon  the  pledge  of  government  bonds  equal  to  90  per  cent 
of  the  par  value  of  the  bonds,  or  of  market  value  if  the  latter  did 
not  exceed  the  par.  The  volume  of  notes  was  originally  limited, 
but  later  the  restriction  was  removed.  The  banks  were  given 
power  to  "  exercise  all  such  incidental  powers  as  shall  seem  neces- 


104  BANKING  AND  CREDIT  [VIII 

sary  to  carrying  on  the  business  of  banking;  by  discounting,  and 
negotiating  promissory  notes,  bills  of  exchange,  and  other  evi- 
dence of  debt;  by  receiving  deposits;  by  buying  and  selling  ex- 
change, coin  and  bullion;  by  loaning  money  on  personal  security; 
and  obtaining,  issuing,  and  circulating  notes."  They  were  not 
permitted  to  purchase  and  hold  real  estate  except  for  a  banking 
house  or  such  as  might  be  conveyed  as  a  security  for  debts  pre- 
viously contracted. 

3.  Growth  of  the  National  Banking  System. — The  special 
inducement  which  early  gave  an  impetus  to  the  new  national 
banking  system  was  the  privilege  of  issuing  circulating  notes 
based  upon  the  pledge  of  United  States  bonds.  This  privilege 
was  made  the  more  valuable  in  1865  by  the  imposition  of  a  heavy 
federal  tax  upon  the  notes  of  state  banks;  many  of  the  latter  in- 
stitutions consequently  found  it  to  their  advantage  to  convert  into 
national  banks. 

The  growth  of  national  banks  is  shown  in  the  following  table : 

1865 1,513  1895 3,706 

1870 1,648  1900 3,942 

1875 2,086  1905 5,833 

1880 2,095  1910 7.204 

1885 2,732  1915 7,607 

1890 3,573  1920 8,093 

In  1900,  national  banks  with  a  capital  of  $25,000,  instead  of 
the  previous  minimum  of  $50,000,  were  authorized,  and  as  a 
result  the  number  of  such  banks  in  the  West  and  South  greatly 
increased,  nearly  doubling  between  1900  and  1910.  In  New 
England  and  some  of  the  eastern  states  the  number  of  national 
banks  has  not  kept  pace  with  the  growth  either  of  the  population 
or  business.  This  is  due  to  the  consolidation  of  small  banks  in  the 
larger  cities  into  one  institution  and  also  to  the  conversion  of 
national  banks  into  trust  companies  which  enjoy  wider  powers 
under  their  state  charters. 


VIII]  BANKING  AND  CREDIT  INSTITUTIONS  105 

National  banks  are  distinctively  commercial  banks  engaged  in 
supplying  short-term  credit.  Some  of  these  institutions,  however, 
have  in  recent  years  engaged,  as  indicated  above,  in  financial 
operations  closely  akin  to  those  of  investment  bankers;  and  more 
recently  by  the  Federal  Reserve  Act  they  have  been  given  power, 
when  not  in  contravention  of  state  or  local  law,  to  act  as  trustee, 
executor,  registrar  of  stocks  and  bonds,  guardian  of  estates, 
assignee,  or  in  any  other  fiduciary  capacity  permitted  by  the  law 
of  the  state  in  which  the  national  bank  is  located.  This  fiduciary 
business  must,  however,  be  segregated  from  commercial  transac- 
tions of  the  bank  and  is  subject  to  the  supervision  of  state 
authority. 

4.  Federal  Reserve  Banks. — In  addition  to  the  national 
banks  holding  federal  charters  there  are  the  twelve  federal  reserve 
banks,  organized  under  the  act  of  19 13.  Their  business  is  largely 
confined  to  dealings  with  national  banks  and  such  state  banks  and 
trust  companies  as  comply  with  certain  regulations  of  the  law. 
These  banks  are  more  particularly  concerned  with  safe-guarding 
the  reserves  of  individual  banks  and  the  issue  of  circulating  notes 
in  rediscounting  for  member  banks.  Their  functions  will  be 
described  in  greater  detail  in  a  later  chapter. 

5.  State  Banks. — Banks  operating  under  state  charters  have 
been  in  existence  for  nearly  a  century  and  a  half.  In  1784  there 
were  2;  in  1800,  28;  in  1850,  824;  and  in  i860,  1,562.  The  imposi- 
tion in  1865  of  a  federal  tax  of  10  per  cent  on  state  bank  note 
issues,  as  well  as  the  prestige  to  be  gained  by  a  national  charter, 
led  many  state  banks  to  convert  into  national  institutions.  In 
1865  there  were  only  349  state  banks.  For  several  years  their 
number  continued  low,  but  the  advantage  of  a  state  charter  for 
carrying  on  business  in  certain  sections  of  the  country  later  led 
to  the  organization  of  many  new  state  institutions,  particularly 
in  the  South  and  West. 


I06  BANKING  AND  CREDIT  [  VIII 

The  reasons  for  the  selection  of  a  state  charter  were  as  follows: 
(i)  Under  the  National  Banking  Act,  until  1900,  no  national  bank 
could  be  established  with  a  capital  of  less  than  $50,000.  This  was 
too  large  for  small  towns  and  the  more  recently  settled  and  poorer 
sections  of  the  country.  (2)  The  restrictions  imposed  by  the 
National  Banking  Act  were  more  severe  than  those  required  by 
most  states.  A  national  bank  could  not  loan  on  real  estate.  In 
the  South  and  West  land  was  the  principal  form  of  property 
which  could  be  offered  as  security  by  the  borrower  and  under  the 
laws  of  most  states  was  admissible  as  collateral  for  loans.  Nor 
did  state  laws  as  a  rule  call  for  as  large  reserves  against  deposits 
as  did  the  federal  act.  Supervision  also  was  less  strict.  When  the 
profit  to  be  gained  by  taking  out  note  circulation  was  no  longer  an 
inducement  to  seek  a  national  charter,  organizers  of  new  banks 
more  frequently  sought  state  charters  because  of  the  greater 
liberality  of  state  laws.  (3)  Naturally  the  southern  states  would 
not  avail  themselves  of  the  privileges  of  the  National  Banking 
Act  in  the  closing  years  of  the  war.  Even  if  they  had  the  re- 
sources, there  was  a  disinclination,  until  prejudice  became  abated, 
to  turn  to  federal  authority  for  a  charter. 

State  banks  are  to  be  found  in  nearly  all  states;  the  only  ex- 
ceptions are  in  the  New  England  states,  Maine,  New  Hampshire, 
Vermont,  and  Massachusetts.  At  the  present  time  regulation  of 
banks  in  many  states  is  as  strict  as  that  imposed  upon  national 
banks,  but  inertia  as  well  as  pride  in  an  historic  past  has  led  many 
of  the  older  state  banks  to  decline  a  national  charter.  Some  of  the 
strongest  banks  in  the  country  are  state  banks.  The  service 
which  state  banks  render  is  substantially  the  same  as  that  of 
national  banks. 

6.  Trust  Companies. — Trust  companies  within  the  past 
quarter-century  have  assumed  a  considerable  part  of  the  banking 
business.  So  far  as  their  charters  are  concerned,  they  are  state 
institutions,  but  some  of  them  in  the  larger  cities  engage  in  a 


VIII 1  BANKING  AND  CREDIT  INSTITUTIONS  1 07 

nationwide  and  international  commercial  banking  business. 
Originally  designed  to  take  care  of  funds  and  estates  committed 
to  their  charge,  thus  taking  the  place  of  the  individual  trustee, 
they  are  now  employed  to  act  as  trustees  under  mortgage,  regis- 
trars and  transfer  agents  for  corporations,  and  more  recently  have 
extended  their  operations  into  every  field  of  banking,  including 
commercial  banking,  care  and  investment  of  savings  deposits, 
and  foreign  exchange. 

The  functions  of  trust  companies  are  summed  up  by  Herrick 
as  follows : ' 

1 .  Business  as  trustee  or  agent  for  individuals  under  private 

agreement. 

2.  Probate  business. 

3.  Investment  business. 

4.  Real  estate  business. 

5.  Insolvency  business. 

6.  Business  as  trustee  or  agent  for  corporations. 

7.  Business  as  transfer  agent  and  registrar  for  corporations. 

8.  Corporation  reorganization  and  financing. 

9.  Fidelity  insurance  and  title  insurance. 

10.  Safe-deposit  business. 

11.  Savings  and  banking  business. 

12.  Miscellaneous. 

Not  all  trust  companies  engage  in  all  these  varieties  of  busi- 
ness, and  in  some  states  their  powers  are  more  carefully  restricted 
than  in  others.  Many  so-called  trust  companies  do  not  transact 
any  trust  business  and  confine  their  operations  to  strictly  com- 
mercial banking,  and  some  of  the  functions  which  formerly  were 
regarded  as  distinctively  the  work  of  trust  companies  are  now 
undertaken  by  national  banks. 

Because  of  the  wide  range  of  operations  covered  by  a  trust 
company,  its  average  size  as  measured  by  capital  is  larger  than 


'  Clay  Herrick,  Trust  Companies  (1909),  P-  34- 


I08  BANKING  AND  CREDIT  [  VIII 

that  of  the  national  or  strictly  commercial  state  bank.  Typical 
trust  companies  are  also  more  numerous  in  the  metropolitan 
cities  and  in  localities  where  large  corporations  need  their  services 
as  agents. 

7.  Savings  Banks. — Savings  banks,  like  state  banks  and  trust 
companies,  are  state  institutions.  The  term  "savings  bank"  is 
loosely  used.  A  strict  definition  confines  its  application  to  insti- 
tutions which  receive  deposits — ^usually  small — ^invest  them,  and 
pay  interest  thereon  to  the  depositors.  Profit  to  the  managers  or 
owners  of  the  bank  is  subordinated  to  the  advantage  of  the  de- 
positors, who  presumably  lack  experience  or  opportunity  in  mak- 
ing individual  investments.  Savings  banks  falling  within  this 
restricted  definition  are  those  established  in  New  England  and 
some  of  the  eastern  states,  a  few  of  the  middle  states,  and  in  Cali- 
fornia and  Washington  on  the  Pacific  Coast.  These  institutions 
have  no  capital  stock  and  are  solely  for  the  interest  of  the  deposi- 
tors; all  profits  accrue  to  them.  They  are  known  as  ''mutual 
savings  banks."  To  increase  the  protection  of  the  depositors, 
the  investments  made  by  the  managers  of  the  banks  are  rigidly 
regulated  by  law.  From  this  point  of  view  Kniffin  gives  the 
following  definition: 

A  savings  bank  is  a  mutual  institution  conducted  without 
profit  to  the  managers,  for  the  purpose  of  receiving  on  deposit 
and  for  safe-keeping,  such  sums  as  may  be  offered,  limited  by  the 
law  of  the  state,  and  investing  the  same  for  account  of  the  de- 
positors jointly  and  severally  in  such  manner  as  shall  be  described 
by  law,  and  paying  to  the  depositors  as  interest  all  the  earnings  of 
the  institution  except  the  amount  paid  for  expenses  and  such  part 
as  may  be  set  aside  and  held  in  reserve  as  a  guaranty  fund  for  the 
benefit  and  protection  of  all.^ 

Such  banks  are  not  privately  engaged  in  commercial  banking, 
many  do  not  accept  checking  accounts,  and  some  do  not  discount 
commercial  paper. 

'  W.  H.  Kniffin.  The  Savings  Bank  and  Its  Practical  Work,  p.  25. 


VIII]  BANKING  AND  CREDIT  INSTITUTIONS  109 

The  term  "savings  bank,"  however,  is  also  applied  to  in- 
stitutions which  have  a  capital  stock  and  where  profit  for  stock- 
holders is  an  underlying  motive.  The  care  of  deposits  even  in  a 
stock  savings  bank  may  be  the  main  object,  or  the  business  of  the 
bank  may  be  extended  to  include  all  the  operations  which  the 
ordinary  commercial  bank  performs.  Iowa  has  926  of  the  1,097 
stock  savings  banks  in  the  country  (19 19),  due  to  the  fact  that  the 
banking  code  of  that  state  is  more  favorable  to  institutions  of  that 
class  than  it  is  to  state  banks.  Such  banks  in  that  state  exercise 
all  the  functions  usually  engaged  in  by  state  banks. 

In  many  towns  and  cities  school  savings  systems  have  been 
established.  Pupils  are  encouraged  to  make  small  deposits  which 
are  transferred  to  local  banks.  School  savings  banks  are  thus 
feed-ers  of  chartered  institutions.  Statistics  compiled  by  the 
American  Bankers  Association  show  for  certain  schools  having  an 
enrolment  of  about  a  million  pupils  in  the  school  year  1919-1920, 
463,000  depositors,  with  nearly  $3  million  deposits.^ 

Industrial  savings  banking  has  also  been  encouraged  by  some 
of  the  large  manufacturing  and  mercantile  companies.  Arrange- 
ments are  made  by  co-operation  with  savings  banks  whereby 
employees  find  convenient  opportunity  to  open  bank  accounts 
and  make  deposits. 

8.  Number  of  Banks. — The  following  table  shows  the  dis- 
tribution in  1919  (June  30)^  of  the  various  kinds  of  banking 
institutions  discussed  or  alluded  to  above,  in  different  sections 
of  the  United  States  (excluding  Hawaii,  Porto  Rico,  and  the 
Philippines) : 

This  table,  compiled  from  returns  to  the  government,  is  only 
approximately  accurate  in  its  classification  of  banks  other  than 
national.    Stock  savings  banks  may  be  included  in  state  banks; 


■!  Full  details  in  regard  to  school  savings  banking  may  be  had  from  the  Savings  Bank 
Division,  American  Bankers  Association.  5  Nassau  St.,  N.  Y. 

^  Report  of  the  Comptroller  of  the  Currency,  1919,  Vol.  II,  pp.  788-789. 


no 


BANKING  AND  CREDIT 


VIII 


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BANKING  AND  CREDIT  INSTITUTIONS 


III 


the  distinction  between  a  state  bank  and  a  trust  company  is  not 
always  clear;  and^the  figure  for  private  banks  is  far  too  low,  as 
the  term  is  loosely  used  in  some  states  and  it  is  difficult  to  draw 
the  line  accurately  between  a  banker  and  a  stock-broker  or  a 
foreign  exchange  dealer.  The  Comptroller  of  the  Currency 
estimates  that  there  are  3,500  private  banks. 

A  little  over  one-fourth  of  the  banking  institutions  in  the 
entire  country  are  organized  under  a  federal  charter.  National 
banks  are  relatively  more  common  in  the  eastern  part  of  the 
country.  Although  state  institutions  (including  trust  companies 
and  private  banks)  far  outnumber  national  banks,  their  financial 
power  is  not  greatly  in  excess  of  that  of  national  banks. 

The  increase  during  the  past  half-century  in  the  number  of 
banks  as  well  as  in  the  volume  of  business  has  been  great.  The 
following  figures  include  commercial  banks  (national,  state,  and 
private),  savings  banks,  loan  and  trust  companies,  and  private 
banks: 

Growth  in  Number  of  Banks 


Year 

Number 

Population 

Ratio  to  Population 

1870 

2,457 

35,558,000 

I  to  15,700 

1880 

3.355 

50,189,000 

I    "  14,900 

1890 

7-999 

63,070,000 

I    "    7,800 

1900 

10,382 

77,257,000 

I    "    7,400 

1910 

23.095 

93,403,000 

I    "    4,000 

1915 

27,062 

100,264,000 

I    "    3,700 

1919 

29,080 

107,690,000 

I    "    3.700 

9.  Branch  Banks. — Unlike  banking  in  foreign  countries,  the 
tendency  in  the  United  States  has  been  to  decentralize  the  busi- 
ness in  the  hands  of  many  independent  institutions.  Although 
several  individual  banks  and  trust  companies  have  grown  to  large 
size,  there  has  been,  ever  since  the  termination  of  the  charter  of 


112  BANKING  AND  CREDIT  |  VIII 

the  Second  United  States  Bank  (1836),  opposition  to  giving  banks 
privileges  which  would  enable  them  to  extend  their  operations 
over  a  wide  extent  of  territory. 

National  banks,  except  institutions  which  were  formerly 
state  banks  and  converted  into  national  banking  associations, 
are  not  permitted  to  operate  domestic  branch  offices.  ^  Under  the 
special  privilege  there  are  16  national  banks  having  60  branches. 
The  Federal  Reserve  Act,  however,  authorizes  national  banks 
to  establish  branches  in  foreign  countries.  Some  banks  have 
availed  themselves  of  this  opportunity:  The  First  National 
Bank  of  Boston  has  a  branch  in  Buenos  Aires,  and  the  National 
City  Bank  of  New  York  has  more  than  fifty  branches  for  the 
most  part  in  Cuba  and  South  America. 

Only  in  a  few  states  are  state  banks  and  trust  companies  per- 
mitted to  have  branches,  and  in  some  of  these  the  privilege  is 
restricted  to  branches  only  in  the  city  in  which  the  main  office 
is  located.  In  state  as  well  as  in  national  bank  legislation  there  is 
a  disposition  to  confine  banking  enterprise  to  local  management. 
As  national  banks  cannot  invest  in  stock  of  other  corporations, 
and  as  in  many  states  similar  laws  prohibit  state  banks  and  trust 
companies  from  investing  in  stocks  of  other  banks,  banks  as  a 
rule  in  the  United  States,  whether  federal  or  state,  are  indepen- 
dent of  each  other.  From  time  to  time  efforts  have  been  made  to 
defeat  the  spirit  of  this  legislation  through  the  ownership  by  a 
person,  or  group  of  persons,  or  a  holding  company,  of  a  controlling 
interest  in  several  banks.  A  few  chains  of  country  banks  have 
been  established;  but  this  development  is  generally  viewed  with 
disfavor  by  supervising  authorities  and  has  made  little  headway. 
A  more  common  extension  of  financial  control  is  through  an 
affiliation  between  a  national  bank  and  a  trust  company  in  the 
same  city.  This  is  done  by  ownership  of  stock  by  the  same  per- 
sons, and  before  the  passage  of  the  Federal  Reserve  Act  was 


s  National  banks  may  also  acquire  local  branches  by  absorbing  state  institutions. 


VIII]  BANKING  AND  CREDIT  IXSTITUTIONS  113 

regarded  as  advantageous  because  of  the  wider  power  granted  to 
trust  companies. 

In  New  York  City  certain  fniancial  leaders  have  large  indi- 
vidual stockholdings  in  more  than  one  bank,  and  undoubtedly 
this  tends  to  build  up  a  centralized  power  in  the  granting  of  credit. 
This  power  is  sometimes  accused  as  a  money  trust  hostile  to 
general  business  welfare  and  bent  on  self-aggrandizement.  There 
is,  however,  more  than  one  powerful  financial  group,  and  no  one 
group  has  sufficient  resources  to  control  the  credit  operations 
which  are  massed  in  New  York  City.  These  groups,  which  are 
primarily  identified  with  great  railroad,  mining,  industrial,  and 
trading  enterprises,  may  be  influenced  to  use  the  banking  agencies 
under  their  control  for  the  promotion  of  these  large  undertakings, 
and  to  subordinate  the  interests  of  business  men  operating  on  a 
small  scale.  This,  however,  is  not  necessarily  intentional  dis- 
crimination directed  against  any  particular  class  and  is  not 
likely  to  succeed  in  gaining  monopoly  profits. 

In  addition  to  the  classes  of  banks  named  above,  there  are 
also  institutions  organized  for  specialized  purposes  in  the  fields 
of  credit  and  care  of  deposits.  Here  are  to  be  noted  the  govern- 
ment postal  savings  system,  the  federal  farm  loan  banks, 
joint-stock  land  banks,  co-operative  banks,  and  building  and 
loan  associations,  credit  unions,  note-brokers,  and  discount 
corporations. 

10.  Postal  Savings  System.— Deposits  in  small  amounts  are 
received  by  post-offices,  and  to  that  extent  the  federal  govern- 
ment engages  in  the  savings  bank  business.  Government  pro- 
tection to  the  depositor  appeals  in  a  special  way  to  immigrants 
who  have  been  in  this  country  but  a  short  time  and  are  ignorant 
of  the  ordinary  opportunities  for  investment  and  protection  of 
savings,  or  are  distrustful  of  banks  organized  for  private  profit. 
The  system  was  inaugurated  in  the  United  States  in  191 1  and  has 
shown  a  considerable  growth;  in   19 19  deposits  amounted  to 


114  BANKING  AND  CREDIT  [VIII 

<$i67  million  made  by  565,000  depositors.  A  portion  of  the 
deposits  is  invested  in  government  bonds,  but  the  larger  part  is 
redeposited  in  banks  in  towns  and  cities  where  the  post-offices  are 
located.  The  amount  which  a  depositor  may  have  at  credit  is 
limited  to  $2,500.    Deposits  bear  interest  at  2  per  cent.^ 

II.  Federal  Land  Banks. — Although  the  United  States  is  an 
agricultural  country,  it  is  only  recently  that  systematic  efforts 
have  been  made  through  governmental  encouragement  and 
supervision  to  supply  credit  to  farmers.  National  banks,  state 
banks,  and  trust  companies  provide  credit  for  commercial  enter- 
prises in  the  manufacture  and  the  marketing  of  commodities. 
They  are  able  to  make  short-term  loans  secured  by  grain,  cotton, 
tobacco  and  staple  products,  and  also  to  make  advances  for 
fattening  cattle  secured  by  chattel  mortgages.  But  the  farmer, 
with  the  increasing  value  of  land  and  the  need  of  investment  in 
expensive  machinery,  has  found  it  more  and  more  difficult  to 
obtain  credit  capital  to  develop  his  enterprise. 

For  many  years  there  have  been  mortgage  companies  or- 
ganized by  private  funds,  and  through  these  a  large  amount  of 
capital  has  been  loaned  by  eastern  investors  to  western  farmers  on 
land  security.  Some  of  them  have  been  well  managed,  while 
others  have  made  farm  loans  on  overvalued  security  and  have 
consequently  failed.  Owing  to  the  lack  of  information  in  regard 
to  the  reliability  of  these  distant  borrowers,  the  element  of  risk 
was  large  and  investors  in  such  loans  insisted  upon  high  rates  of 
interest.  When  farmers  in  New  England  were  able  to  borrow  on 
mortgages  at  6  per  cent  or  less,  those  in  the  South  and  West  paid 
as  high  as  8  or  9  per  cent.  Farmers,  particularly  in  the  West, 
demanded  relief;  and  about  1908  there  began  a  public  agitation 
for  an  extension  of  agricultural  credit.  The  Federal  Reserve  Act 
(19 13)  gave  some  relief  by  granting  rediscount  privileges  on  short- 


^  See  annual  letter  from  the  Postmaster-General  on  operations  of  the  postal  savings 
system. 


vim  BANKING  AND  CREDIT  INSTITUTIONS  1 15 

term  agricultural  and  livestock  paper;  but  no  provision  was  made 
for  farmers  who  sought  funds  for  longer  periods. 

Finally,  in  1916,  Congress  passed  the  Federal  Farm  Loan  Act. 
This  divides  the  United  States  into  twelve  districts  in  each  of 
which  there  is  a  federal  land  bank.  These  banks  make  loans  on 
first  mortgage  security  to  farmers  engaged  in  actual  cultivation 
of  the  land.  Funds  for  the  loans  are  obtained  by  the  sale  of  bonds 
secured  by  the  mortgages.  As  these  mortgages  are  pooled  to- 
gether and  are  carefully  selected,  the  security  of  the  bond  is 
greatly  strengthened  as  compared  with  the  purchase  of  a  mort- 
gage note  secured  by  but  a  single  parcel  of  land.  The  federal 
land  bank,  howTver,  does  not  make  the  loan  directly  to  the  in- 
dividual borrower,  but  deals  with  local  farm  loan  associations. 
These  associations  are  co-operative  in  character,  each  member 
owning  stock  in  proportion  to  his  borrowing,  and  all  applications 
for  loans  must  first  be  approved  by  the  association  before  being 
forwarded  to  the  federal  land  bank.  The  association  also  is  liable 
by  indorsement  for  the  loan  made  by  the  bank.  Under  this  pro- 
cedure, involving  intimate  knowledge  and  mutual  responsibility, 
it  is  thought  that  the  loans  are  amply  protected.  Individual  loans 
are  limited  to  $10,000  and  extended  only  on  first  mortgages  to  an 
amount  not  exceeding  50  per  cent  of  the  value  of  the  land  and  20 
per  cent  of  the  value  of  insured  improvements.  The  loans  must  be 
paid  off  in  instalments,  running  over  a  period  from  five  to  forty 
years.  The  rate  of  interest  does  not  exceed  by  more  than  i  per 
cent  the  rate  paid  on  farm  loan  bonds. 

The  capital  of  the  land  banks  is  provided  by  the  United  States 
government  and  the  farm  loan  associations.  The  banks  are  jointly 
liable  for  all  bonds  issued  and  the  latter  are  made  attractive  to 
investors  by  being  exempt  from  all  federal,  state,  and  local  taxes. 
The  federal  land  banks  also  supervise  certain  joint-stock 
land  banks,  which  are  managed  by  private  enterprise  and  can 
make  loans  under  more  liberal  conditions  than  can  the  farm  loan 
associations. 


Il6  BANKING  AND  CREDIT  [  VIIl 

This  system  of  rural  or  agricultural  credit  has  made  a 
steady  though  slow  progress.  In  1920  the  loans  of  the  federal 
land  banks  amounted  to  $350  million,  and  of  the  joint-stock  land 
banks  to  $78  million.  It  is  estimated  that  nearly  two-thirds  of 
the  loans  have  been  made  to  liquidate  existing  debts  of  farmers 
and  the  remainder  to  finance  new  purchases  of  land  or  improve- 
ments. 

12 .  Co-operative  Banks  and  Building  and  Loan  Associations. 

— In  some  parts  of  the  country,  associations  have  been  organized 
to  encourage  savings  to  be  applied  to  the  building  of  homes. 
These  are  known  by  different  names,  as  "  savings  and  loan  associa- 
tions," "building  associations,"  "building  and  loan  associations," 
" co-operative  loan  associations,"  or  "co-operative  banks."  The 
members  contribute  periodically,  generally  monthly,  certain 
stated  small  sums  to  the  purchase  of  shares;  and  these  payments 
are  then  loaned  to  members,  as  a  rule  for  the  building  of  homes. 
Such  institutions  do  not  engage  in  commercial  banking  and  are 
restricted  .in  common  practice  to  loans  on  real  estate.  In  some 
states  these  institutions  have  played  a  large  part  in  the  encourage- 
ment of  thrift  and  the  making  of  homes.'' 

In  19 1 8  there  were  7,484  such  associations  in  the  United 
States,  of  which  more  than  a  fourth  (2,124)  were  in  Pennsylvania 
alone.  New  Jersey  came  next  with  792,  followed  by  Ohio  with 
723,  and  Illinois  with  681.  These  associations  had  a  membership 
of  4  millions,  and  assets  of  nearly  $2  billion. 

The  operations  of  these  institutions  may  be  illustrated  by  a 
brief  analysis  of  the  reports  of  co-operative  banks  in  Massachu- 
setts. In  19 1 9  there  were  190  banks,  having  a  total  membership 
of  261,979.  Each  member  subscribes  for  at  least  one  share,  the 
matured  value  of  which  is  $200.  Payments  for  these  shares  are 
made  by  instalments,  at  the  rate  of  $1  per  month.    The  number 


"  For  details  in  regard  to  these  institutions,  see  H.  S.  Rosenthal,  Cyclopedia  of  Building, 
Loan  and  Savings  Associations  (fourth  edition,  1920). 


villi  BANKING  AND  CREDIT  INSTITUTIONS  I17 

of  shares  was  2,514,763  in  19 19,  making  an  average  number  held 
by  each  member  of  9.6.  The  total  amount  received  during  the 
year  on  payments  for  shares  was  $29,037,544.  Loans  were  made 
to  78,590  members,  or  to  about  one  in  three  of  the  total  member- 
ship. The  loans  were  secured  by  mortgages  on  real  estate  or  by  a 
pledge  of  the  shares  on  which  partial  payments  had  been  begun. 
The  average  rate  of  dividend  earned  by  each  share  was  5.27  per 
cent,  and  the  average  rate  of  interest  charged  on  real  estate  loans 
was  5.70,  and  on  share  loans  5.85  per  cent. 

The  total  assets  of  all  these  associations  in  Massachusetts  was 
$154,880,000,  of  which  $142,494,000  was  represented  by  loans  on 
real  estate.  Since  co-operative  banks  were  first  organized  in  that 
state  in  1879,  393,543  shares,  amounting  to  $78,636,000,  have 
reached  their  matured  value,  and  this  was  repaid  to  78,671  share- 
holders. These  either  used  the  proceeds  to  pay  their  loans,  if 
borrowers,  or  withdrew  their  money;  opportunity,  however,  is 
given  to  leave  the  money  with  the  bank  on  deferred  maturity 
certificates  on  which  interest  is  paid. 

13.  Credit  Unions. — People's  banks,  co-operative  credit  as- 
sociations, or  credit  unions,  have  long  been  established  in  Europe 
and  more  recently  in  other  parts  of  the  world.  In  1913  it  was 
estimated  that  there  were  throughout  the  world  6,500  credit 
unions,  having  a  membership  of  1 5  millions.  The  object  of  these 
institutions  is  to  organize  individuals  in  a  small  community,  or  of 
kindred  interest,  as  industrial  units,  factories,  and  neighborhood 
groups,  so  that  their  combined  resources  may  be  available  for 
mutual  loans. 

Efforts  have  been  made  to  introduce  similar  systems  into  the 
United  States,  but  apparently  a  new  country  with  a  scattered  and 
fluctuating  population  has  not  been  congenial  for  the  growth  of 
credit  institutions  which  depend  in  a  large  measure  upon  mutual 
trust  and  confidence.  A  small  beginning,  however,  has  been 
made,  Massachusetts  taking  the  lead  in  1909,  and  her  example  has 


Il8  BANKING  AND  CREDIT  [VIII 

been  followed  by  a  few  other  states.  Uncler  the  law  of  New  York, 
which  is  typical,  seven  or  more  persons  may  organize  a  credit 
union.  The  basis  of  membership  is  good  moral  character.  Deal- 
ings are  made  with  members  only.  Each  member  is  required  to 
subscribe  for  one  share,  usually  $5  in  value.  Deposits  are  received 
and  loans  are  made  for  not  more  than  one  year.  A  maximum  rate 
of  interest  of  not  more  than  i  per  cent  per  month  is  allowed.  All 
members  share  equally  in  privileges  and  management,  and  ratably 
in  profits.  The  chief  purpose  is  to  supply  small  loans  to  members, 
most  of  whom  are  not  in  a  position  to  obtain  credit  of  a  bank.  A 
shareholder  or  member  is  permitted  to  borrow  four  or  five  times 
the  value  of  his  holdings,  such  loans  being  repayable  in  weekly 
instalments.  By  this  means  the  seeker  of  credit  avoids  the  ex- 
cessive rates  of  interest  charged  by  the  so-called  "loan  shark." 
The  credit  union  "does  not  become  a  substitute  for  the  building 
and  loan  association  or  the  remedial  loan  society — instead  it 
becomes  a  complement  of  these  agencies,  for  the  basis  of  the 
security  for  its  loans  is  not  collateral  but  character."^ 

Credit  unions  in  the  United  States  are  still  in  the  early  de- 
velopmental stage.  The  Bank  Commissioner  of  Massachusetts  in 
a  recent  report  refers  to  the  danger  that  exists  for  these  institu- 
tions, since  the  majority  of  the  loans  are  made  to  those  who 
possess  little  more  than  their  health  and  good  character.  He 
notes,  however,  that  the  losses  in  making  loans  of  over  $3  million 
in  1920  were  practically  negligible  and  concludes  that  there  is 
"much  to  be  said  in  favor  of  credit  unions."^ 

14.  Morris-Plan  Banks. — The  Morris-plan  banks  are  also 
designed  to  aid  persons  without  property  to  borrow  at  moderate 
rates  of  interest.  Loans  are  made  on  character  to  any  person  who 
wishes  to  borrow  for  a  useful  purpose  only  and  who  can  secure 
two  persons  to  indorse  his  note.    Loans  are  made  for  one  year 

*  Credit  Union  Primer,  published  by  Russell  Sage  Foundation.  1914. 

'Annual   Report   of  the   Bank   Commissioner    of   Massachusetts,    1919,   Part    11,   p. 


villi  BANKING  AND  CREDIT  INSTITUTIONS  II9 

and  the  borrower  agrees  to  pay  one- fiftieth  of  the  total  sum  each 
week  as  instahnents  on  the  purchase  of  Morris-plan  certificates, 
which  may  be  converted  into  cash  to  meet  the  loan  at  maturity. 
For  example ,  on  a  loan  of  $  1 00  a  borrower  agrees  to  buy  two  certifi- 
cates at  $50  each;  he  pays  $1  a  week  on  each  certificate,  and  at 
the  end  of  fifty  weeks  he  has  fully  paid  for  them.  He  can  then 
cash  them  to  repay  his  loan,  or  retain  the  certificates  as  an  in- 
vestment and  repay  his  loan  with  other  funds.  Discount  at  the 
rate  of  6  per  cent  per  annum  is  deducted  when  the  loan  is  made, 
and  there  is  an  investigation  charge  paid  by  the  borrower  of  $1 
for  each  $50  borrowed,  but  not  to  exceed  $5  no  matter  how  large 
the  loan  may  be.  The  first  of  the  companies  was  organized  in 
1910;  in  1918  there  were  over  100.  Approximately  $100  milHon 
was  loaned  in  the  latter  year. 

15.  Discount  Companies. — In  the  United  States  discount 
companies,  also  known  as  "commercial  credit  companies," 
"finance  companies,"  and  "automobile  banks,"  etc.,  are  com- 
paratively new.'"  In  Great  Britain  and  Germany,  however, 
such  companies  have  been  operating  for  many  years.  There  is  a 
considerable  variation  in  the  kind  of  business  carried  on  by  these 
concerns,  but  in  general  there  are  two  important  and  fairly  dis- 
tinct types  of  enterprise :  ( i )  the  financing  of  the  distribution  of 
automobiles,  pianos,  furniture,  and  articles  sold  on  the  instalment 
plan;  and  (2)  the  converting  of  accounts  receivable  into  cash  for 
merchant  and  manufacturer.  Both  of  the  types  borrow  heavily 
from  commercial  banks  and  are  thus  able  to  shift  the  burden  of 
their  loans. 

The  first  of  these  two  types  of  finance  companies  deals  largely 
in  paper  arising  from  the  sale  of  goods  on  the  instalment  plan. 
In  the  automobile  field,  for  instance,  there  has  been  a  wide  de- 
mand for  financial  assistance  from  this  source  for  the  reason  that 


'"  Unfortunately  the  term  "discount  company"  is  used  rather  loosely  and  may  refer 
to  firms  such  as  described  here  and  also  to  houses  which  purchase  commercial  paper  from 
banks  and  in  the  open  market. 


I20  BANKING  AND  CREDIT  [VIII 

the  regular  commercial  banks  have  looked  upon  the  automobile 
as  involving  too  great  risks  to -warrant  loans  on  an  extensive  scale 
to  dealers  and  buyers.  In  general  there  are  two  classes  of  auto- 
mobile finance  companies:  (i)  the  large  companies  which  extend 
credits  to  dealers  secured  by  chattel  mortgages  on  their  cars,  and 
(2)  the  smaller  concerns  which  specialize  in  making  retail  loans 
secured  by  the  instalment  notes  of  the  individual  buyers.  Some 
of  these  finance  companies,  however,  do  business  with  both 
dealers  and  individual  buyers  as  well  as  purchase  accounts 
receivable. 

16.  Conversion  of  Receivables. — Discount  companies  which 
specialize  in  buying  accounts  receivable  deal  exclusively  with 
manufacturers  and  merchants  selling  on  credit.  When  a  manu- 
facturer or  a  merchant  sells  a  bill  of  goods  to  a  customer  on  credit, 
a  portion  of  his  capital  is  locked  up  in  the  merchandise  until  the 
customer  makes  remittance.  Therefore  the  common  trade  prac- 
tice is  to  offer  the  buyer  an  inducement  to  pay  promptly  and  bills 
are  usually  rendered  on  some  such  terms  as:  "  2  per  cent  10  days, 
net  30  days."  This  means  that  the  seller  will  take  2  cents  ofT 
every  dollar  on  the  bill  if  the  buyer  will  accommodate  the  seller 
by  paying  20  days  in  advance  of  the  net  due  date.  That  is  to  say, 
for  the  use  of  this  money  20  days  before  due,  the  seller  will  allow 
a  rebate  of  i  per  cent  for  each  10  days.  As  there  are  roughly  36 
times  10  days  in  the  year  this  means  that  he  is  willing  to  pay  at 
the  rate  of  36  per  cent  per  annum  for  the  use  of  the  money  20  days 
in  advance  of  any  30-day  due  date.  While  there  are  many  pros- 
perous concerns  that  take  advantage  of  this  2  per  cent  discount, 
there  is  a  large  proportion  of  buyers  who  take  the  full  term  of  30 
days  or  more  and  the  seller  has  to  wait  for  his  money.  At  this 
point  the  discount  corporation  steps  in  and,  at  a  rate  lower  than 
what  the  seller  offers  the  trade,  advances  him  money  for  immedi- 
ate use,  thus  capitalizing  his  accounts  receivable. 

Open  accounts,  receivables,  and  trade  acceptances  (although 


villi  BANKING  AND  CREDIT  INSTITUTIONS  121 

the  last  two  items  are  a  much  less  important  part  of  the  business 
of  a  discount  company  than  the  first  item)  are  purchased  by 
initially  paying  75  per  cent  of  the  face  value  of  the  account  and 
holding  in  reserve  25  per  cent  until  the  entire  account  has  been 
paid.  These  percentages  are  basic  and  are  departed  from  in 
certain  cases,  depending  upon  the  character  of  the  transaction. 
When  the  entire  account  has  been  paid  the  discount  company 
deducts  its  fees  and  credits  the  client  with  the  balance.  The  sale 
or  assignment  of  accounts  receivable  to  a  discount  company  is 
generally  without  the  knowledge  of  the  merchant's  or  manu- 
facturer's customers.  However,  in  case  of  financial  difficulties 
of  the  merchant  or  manufacturer  who  has  sold  his  receivables  the 
discount  company,  in  order  to  protect  its  interests,  will  notify  the 
customers  and  request  them  to  make  payments  direct  to  the  dis- 
count company. 

17.  Interest  Charge  of  Discount  Companies. — The  interest 
rates  charged  by  discount  companies  are  commonly  in  the 
neighborhood  of  24  per  cent  per  year,  varying,  of  course,  with  the 
risk  involved  and  the  general  level  of  interest  rates.  These  rates 
are  applied  in  some  such  manner  as  this :  When  an  applicant  for 
credit  submits  a  schedule  of  accounts  receivable  he  is  charged 
yi  per  cent  as  an  initial  fee  and  this  charge  is  made  each  time  he 
submits  such  a  statement.  He  is  then  charged  at  the  rate  of  i 
per  cent  per  month  for  the  term  of  the  credit.  Assuming  that  the 
accounts  run  30  days,  these  two  charges  are  equivalent  to  a  rate  of 
18  per  cent  per  year,  but  since  the  discount  company  advances  to 
its  client  only  75  per  cent  of  the  face  value  of  the  accounts  and 
charges  him  on  the  basis  of  100  per  cent  the  real  rate  of  interest 
becomes  24  per  cent.  Where  discount  companies  are  run  on  a 
conservative  basis  the  element  of  credit  risk  is  very  small.  The 
discount  company  is  protected  by  the  standing  of  the  client  and 
the  latter's  customer.  The  contract  entered  into  between  the 
client  and  the  discount  company  is  of  such  a  character  that  the 


122  BANKING  AND  CREDIT  [VIII 

client  places  himself  in  a  position  of  a  trustee  of  the  funds  which 
he  receives  from  his  customer.  To  violate  the  trust  relationship 
is  a  criminal  act. 

The  question  may  naturally  arise  as  to  why  merchants  and 
manufacturers  should  find  it  necessary  to  resort  to  discount  com- 
panies instead  of  commercial  banks  where  interest  rates  are  sub- 
stantially lower.  In  the  period  of  expansion  during  and  following 
the  war,  large  profits  induced  business  houses  to  borrow  on  a  very 
large  scale.  In  many  instances  they  exhausted  their  borrowing 
capacity  at  their  banks  and  found  it  desirable  to  apply  to  dis- 
count companies  for  further  credit.  Other  concerns  that  were  not 
able  to  form  proper  banking  connections  resorted  to  this  expensive 
method  of  obtaining  credit.  Although  the  high  rates  of  inter- 
est charged  by  discount  companies  might  seem  to  be  prohibitive, 
nevertheless  business  concerns  find  it  to  their  advantage  to  pay 
these  charges  under  certain  conditions.  In  a  period  of  rising 
prices  and  large  profits  seemingly  high  interest  rates  can  usually 
be  absorbed  by  higher  prices  paid  by  the  buyer.  Again  there  are 
always  certain  business  concerns  which  on  account  of  having 
recently  started  or  for  other  reasons  have  not  been  able  to  estab- 
lish satisfactory  banking  connections.  Particularly  in  times  of 
actual  or  anticipated  financial  difficulties  such  concerns  are  will- 
ing, if  necessary,  to  pay  high  interest  rates  for  the  use  of  funds. 

i8.  Organization  of  Banks. — As  already  pointed  out,  nearly 
all  banking  business  is  carried  on  by  chartered  corporations.  The 
investment  of  capital  is  subject  to  the  terms  of  the  charter,  and 
experience  has  led  legislative  bodies  to  make  special  regulations 
which  not  only  supervise  the  operations  of  banking  institutions 
after  they  are  chartered  but  lay  down  rules  in  regard  to  their 
organization.  Capital  is  not  free  to  enter  the  banking  business 
under  corporate  direction  except  upon  compliance  with  regula- 
tions which  are  far  more  strict  than  are  found  in  most  other  forms 
of  enterprise.    This  is  particularly  true  of  national  banks  where 


VIII]  BANKING  AND  CREDIT  INSTITUTIONS  1 23 

the  assent  of  the  federal  government  through  the  Comptroller 
of  the  Currency  is  necessary.  Even  the  states  which  permit 
incorporation  under  a  general  law  rather  than  by  special  legisla- 
tive charter,  require  as  a  rule  the  permission  of  some  state  ofiticial. 
It  has  been  learned  by  experience  that  many  bank  failures  are  due 
to  lax  provisions  of  organization,  as  in  the  irresponsibility  of  the 
promoters,  or  in  the  non-payment  of  initial  capital  necessary  to 
engage  in  the  business.  At  no  stage  in  a  bank's  life  is  govern- 
mental supervision  now  more  strict  than  at  its  formation. 

19.  Organizing  a  National  Bank. — To  assist  organizers  of 
national  banks  a  pamphlet  of  instructions  based  upon  statute  law 
is  furnished  by  the  Comptroller  of  the  Currency.  It  advises  in 
regard  to  the  several  steps  of  procedure  to  be  taken. 

In  brief,  an  application  is  made  by  five  prospective  share- 
holders, with  indorsement  by  persons  who  can  certify  as  to  the 
responsibility  of  the  applicants  and  the  desirability  of  establishing 
the  new  bank.  Here  the  Comptroller  exercises  care  in  scrutinizing 
the  speculative  plans  of  promoters  who  are  not  immediately  con- 
cerned with  the  banking  needs  of  the  community  in  which  the 
bank  is  to  be  placed.  Such  apphcations,  moreover,  should  not  be 
attended  with  extraordinary  organization  expenses.  The  Comp- 
troller also  considers  the  relations  of  the  applicants  to  other  banks. 
Upon  approval  of  the  Comptroller  a  stock  subscription  list  is 
prepared  showing  the  list  of  subscribers.  One-half  of  the  capital 
must  be  paid  in  at  once  and  the  balance  in  five  monthly  instal- 
ments. In  order  to  strengthen  the  position  of  the  bank,  the  crea- 
tion of  a  surplus  by  the  initial  stockholders  at  organization  is 
recommended.  A  temporary  certificate  is  then  granted  and  ar- 
ticles of  association  are  drawn  up,  and,  if  satisfactory,  a  perma- 
nent organization  certificate  is  issued.  Directors  are  elected  who 
take  oath  for  the  performance  of  their  duties.  Upon  presentation 
of  a  certificate  evidencing  the  payment  of  the  capital  stock, 
authority  is  finally  given  by  the  Comptroller  to  begin  business. 


124  BANKING  AND  CREDIT  [VIII 

A  charter  runs  for  twenty  years  and,  if  desired,  is  as  a  rule  re- 
newed at  the  expiration  of  the  period. 

Not  all  applications  are  favorably  considered.  In  the  year 
ending  October  31,  1919,  there  were  422  applications;  15  were 
rejected  and  46  abandoned  or  indefinitely  deferred.  Rejections 
were  based  upon  the  fact  that  there  were  already  adequate  bank- 
ing facilities,  or  that  the  population  and  business  were  too  limited 
to  warrant  success,  or  that  the  financial  standing  or  character  of 
the  applicant  was  not  satisfactory. 

The  laws  of  the  several  states  regulating  the  organization  of 
state  banks  vary.  In  some  states  the  provisions  of  the  national 
bank  statute  are  followed,  particulary  as  to  the  paying-in  of  50 
per  cent  of  the  capital  before  the  bank  begins  business.  Greater 
elasticity  prevails  as  to  the  time  of  payment  of  the  balance,  the 
period  ranging  from  90  days  to  21/2  years.  In  a  few  states 
the  entire  capital  must  be  paid  in  before  the  transaction  of  any 
business. ' ' 

References 

Agger,  E.  E.     Organized  Banking. 

Trust  companies,  state  banks,  private  banks,  pp.  222-22Q. 
Fiske,  A.  K.     The  Modern  Bank. 

On  state  banks  and  trust  companies,  pp.  225-234 ;  on  private  banks, 
pp.  235-240;  on  savings  banks,  pp.  257-267. 
Holdsworth,  J.  T.     Money  and  Banking. 

Organizing  a  national  bank,  pp.  170-174;  savings  banks,  pp.  300- 
308;  trust  companies,  pp.  309-318. 
Kirkbride,  F.  B.,  and  Sterrett,  J.  E.     The  Modern  Trust  Company. 

This  edition  (5th)  contains  additional  chapters  by  H.  P.  Willis;  a 
practical  treatment  of  the  operations  of  different  parts  of  a  trust 
company,  with  a  bibliography,  pp.  513-525. 
Knififin,  W.  H.     The  Business  Man  and  His  Bank.     pp.  5-18. 

The  Savings  Bank  and  Its  Practical  Work. 

A  detailed  and  descriptive  treatment  written  by  the  treasurer  of  a 
savings  bank. 


G.  E.  Barnett,  State  Banks  and  Trust  Companies,  pp.  23-34. 


VIII]  BAxNKING  AND  CREDIT  INSTITUTIONS  125 

Moulton,  H.  CI.     Financial  Organization  of  Society. 
Chap.  17,  Trust  Companies. 
Chap.  18,  Savings  Institutions. 

Chap,  iq,  Practical  Operations  of  a  Commercial  Bank. 
Chap.  28,  Consumptive  Credit  Institutions    (Morris-plan    Ijanks, 
credit  unions  and  building  and  loan  associations). 

Principles  of  Money  and  Banking.     Part  II. 

Trust  companies,  pp.  215-224;  building  and  loan  associations,  pp. 
354-362;  savings  banks,  pp.  402-425. 
Phillips,  C.  A.     Readings  in  Money  and  Banking. 

Trust  companies,  pp.  256-269;  savings  banks,  pp.  270-289. 
Rosenthal,  H.  S.     Encyclopedia  of  Building,  Loan  and  Savings  Associa- 
tions. 
United  States.     Bureau  of  Foreign  and  Domestic  Commerce.     Statistical 
Abstract. 

Statistics  of  banks  and  tables. 

Comptroller  of  the  Currency.     Annual  Reports. 

Statistics  in  regard  to  various  classes  of  banks.     Vol.  1  contains 
summarized  statements. 
Wcsterfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  I,  pp.  183- 

186;  Vol.  II,  pp.  236-257,  431-434. 
White,  H.     Money  and  Banking.     Chapter  15,  State  Banks  and   Trust 

Companies. 
Willis,  H.  P.     American  Banking,     pp.  10-22. 
and  Edwards,  G.W.     Banking  and  Business,     pp.  311-332,333-352. 


CHAPTER  IX 
THE  BALANCE  SHEET  OF  A  BANK 

I.  The  Balance  Sheet  Equation. — The  explanation  of  the 
business  operations  of  banks  and  the  nature  of  their  financial 
structure  is  best  introduced  by  the  consideration  of  the  balance 
sheet  of  a  commercial  bank.  This  involves  a  brief  discussion  of 
certain  fundamental  aspects  of  accounting. 

A  balance  sheet  in  accounting  practice  is  a  statement  of  the 
financial  condition  of  a  business  at  a  given  date.  It  is  based  upon 
a  very  simple  but  highly  useful  mathematical  equation  which 
may  be  stated  in  this  form : 

Resources  (assets)  =  Liabilities  +  Net  Worth 

Resources  represent  all  valuable  items  of  property,  whether  ma- 
terial or  in  the  form  of  claims  against  others  in  the  possession  of  a 
business.  Liabilities,  strictly  speaking,  mean  the  obligations  of 
the  business  to  its  creditors. 

As  a  matter  of  accounting  and  financial  practice,  the  term 
"liabilities,"  as  used  in  the  balance  sheet  or  statement  of  assets 
and  liabilities,  refers  both  to  obligations  of  a  business  to  its  credi- 
tors, such  as  individual  depositors,  other  banks,  and  note-holders, 
and  to  the  net  worth  or  residual  claim  of  the  stockholders  or  pro- 
prietors. In  the  case  of  a  typical  commercial  bank,  net  worth  is 
composed  of  the  items,  capital  stock,  surplus,  and  undivided 
profits.  The  main  sources  from  which  accretions  to  net  worth  are 
derived  are  contributions  by  the  stockholders  and  earnings  from 
operations.  It  is  the  practice  in  banking,  as  in  other  lines  of 
business,  to  carry  the  capital  stock  item  on  the  balance  sheet  at 
the  par  value  of  the  outstanding  stock.  No  change  is  made  in 
this  account  except  when  new  stock  is  sold  or  a  part  of  the  old 

126 


IX]         THE  BALANCE  SHEET  OF  A  BANK  1 27 

stock  is  canceled,  or  to  record  an  increase  of  capital  stock  through  a 
declaration  of  a  stock  dividend.  Banks,  however,  rarely  declare 
stock  dividends.  Necessarily  changes  in  the  net  worth  as  a  result 
of  operations  will  be  reflected  in  the  items,  undivided  profits  and 
surplus. 

Surplus  and  undivided  profits  in  themselves  are  nothing 
tangible,  such  as  a  cash  fund  or  securities.  But  these  accounts 
together  with  capital  stock,  deposits,  and  all  other  items  appear- 
ing under  liabilities,  are  offset  by  the  various  items  included  under 
resources,  as,  for  example,  loans,,  bonds,  etc.  That  no  causal  re- 
lation exists  between  cash  and  surplus  may  be  indicated  by  the 
fact  that  a  bank's  cash  may  be  dwindling  while  its  surplus  is 
increasing.  Surplus  and  undivided  profits  differ  from  capital 
or  capital  stock  by  not  being  represented  by  stock  certificates, 
although  the  size  of  the  surplus  and  undivided  profits  tends  to  be 
reflected  in  the  market  price  of  the  capital  stock. 

2.  Typical  Banking  Transactions. — Upon  organization  of  a 
bank  with  capital  of  $100,000,  which  is  fully  paid  in  by  the  stock- 
holders, the  balance  sheet  will  read: 

A 

Resources                                                   Liabilities 
Cash $100,000       Capital $100,000 

The  bank  must  then  secure  a  place  of  business.  This  it  may 
do  either  by  renting  an  office,  or  by  purchasing  and  equipping  a 
place  of  business.  If  it  adopts  the  second  method  it  will  own 
among  its  resources  so  much  real  restate.  The  bank  thus  invests 
$15,000  in  a  business  house,  and  the  balance  sheet  will  read: 

B 

Resources  Liabilities 

Banking  house,  furniture,  Capital $100,000 

and  fixtures $15,000 

Cash 85,000 

$100,000  $ico,ooo 


128  BANKING  AND  CREDIT  f  IX 

The  bank  is  now  ready  to  do  business,  the  most  important 
forms  of  which  are  to  make  loans  and  to  receive  deposits.  Loans, 
or  the  advance  of  credit,  may  be  made  in  a  variety  of  ways,  which 
will  be  more  fully  described  later.  In  general  they  may  be  divided 
into  two  classes:  (i)  discounts,  and  (2)  straight  loans.  The  only 
difference  between  a  discount  and  a  straight  loan  is  one  of  form. 
In  the  former  the  principal  and  interest  are  merged  in  one  sum 
for  convenience  in  negotiation;  in  the  latter  the  principal  and 
interest  are  expressed  separately,  with  the  expectation  that  the 
note  will  be  held  by  the  lender  to  maturity.  While  discounts 
are  entered  by  banks  at  their  full  amount,  they  are  really  carried, 
as  shown  in  the  examples,  at  their  true  value — the  original  prin- 
cipal (discounted  sum)  and  accrued  interest  (earned  discount) — 
by  reason  of  the  offsetting  item,  "Unearned  discount,"  among  the 
liabilities.  In  other  words,  discounts  are  handled  precisely  as 
straight  loans  are. 

The  bank  first  loans  $10,000  in  cash  for  3  months  on  which  it 
charges  7  per  cent  interest,  the  interest  to  be  paid  when  the  note 
falls  due.    The  statement  will  then  read: 

C 

Resources  Liabilities 

Loans $10,000       Capital $100,000 

Banking  house,  furniture, 

and  fixtures 1 5,000 

Cash 75.000 

$100,000  $100,000 

Depositors  open  accounts  and  leave  $5,000  in  cash.  The  bank 
has  assumed  a  new  liability  and  the  balance  sheet  is  as  follows: 

D 

Resources  Liabilities 

Loans |io,ooo      Capital $100,000 

Banking  house,  furniture,  Deposits 5,000 

and  fixtures 15,000 

Cash 80,000 

$105,000  $105,000 


IX  I         THE  BALANCE  SHEET  OF  A  BANK  1 29 

The  bank  makes  a  further  loan  of  $9,000  for  2  months  at  6 
per  cent,  discounting,  however,  the  borrower's  note.  The  interest 
on  $9,000  for  2  months  at  6  per  cent  is  $90. '  The  borrower,  who 
is  under  obhgation  to  pay  back  $9,000,  receives  in  cash  $8,910. 
The  item  of  $90  is  carried  on  the  Habilities  side  of  the  statement 
under  some  such  title  as  "Interest  and  discount  collected  or 
credited  in  advance  of  maturity  and  not  earned."  Beginning  as 
of  January  i,  19 19,  the  Comptroller  of  the  Currency  required  all 
national  banks  to  carry  their  earnings  on  a  basis  classified  as  to 
"Discount  collected  and  unearned"  (liabilities)  and  "Interest 
accrued  but  uncollected"  (assets).  Previous  to  that  date  it  was 
the  general  practice  for  national  banks  to  include  discounts  col- 
lected in  advance  immediately  in  the  undivided  profits  account. 
State  banks  still  follow  this  practice  commonly. 

Resources  Liabilities 

Loans  and  discounts $19,000       Capital $100,000 

Banking  house,  furniture,  Interest  and  discount  col- 

and  fixtures 15,000  lected    or    credited    in 

Cash 71 ,090  advance  of  maturity  and 

not  earned  (approximate)'  90 

Deposits 5,000 


$105,090  $105,090 

In  subsequent  operations  on  the  same  day  the  bank  invests 
$6,000  of  its  cash  in  stocks  and  bonds,  and  deposits  $15,000  with 
a  bank  in  New  York  City.  Each  of  these  operations  decreases 
the  cash  and  the  statement  reads: 


'  It  is  the  general  practice  in  American  banking  to  compute  interest  and  discount  on  the 
basis  of  30  days  to  a  month  and  360  days  to  a  year. 

*  It  is  assumed  that  balance  sheets  E-J  inclusive  are  for  the  same  day.  If,  instead,  it 
were  assumed  that  a  number  of  days  had  elapsed  between  the  several  transactions  two  slight 
changes  in  the  statements  would  be  necessary.  On  the  liabilities  side  the  item.  "Interest 
and  discount  collected  or  credited  in  advance  of  maturity,  but  not  earned  (approximate)" 
would  be  gradually  transferred  to  the  undivided  profits  account  on  the  basis  of  the  time 
actually  elapsed.  Similarly,  on  the  assets  side  of  the  statement  there  would  anpear  an  item, 
"  Interest  earned  but  not  collected  (approximate)  on  notes  and  bills  receivable"  which  would 
be  offset  under  liabilities  by  an  increase  in  undivided  profits  of  the  same  amount. 

In  the  above  example  the  term  "approximate"  may  seem  inappropriate,  as  the  interest 
computed  is  the  exact  sum.  However,  in  actual  practice  this  would  rarely  happen  and  the 
title  consequently  has  not  been  changed. 


I30 


BANKING  AND  CREDIT 


IX 


Resources 

Loans  and  discounts $19,000 

Banking  house,  furniture, 

and  fixtures 15,000 

Securities,     stocks,     and 

bonds 6,000 

Due  from  other  banks ....  15,000 

Cash 50,090 

$105,090 


Liabilities 

Capital $100,000 

Interest  and  discount  col- 
lected or  credited  in 
advance  of  maturity  and 
not  earned  (approximate)  90 

Deposits 5,000 


$105,090 


Again,  on  the  same  day  the  bank  makes  a  loan  of  $18,000  for 
2  months  at  6  per  cent,  the  borrower  agreeing  informally  that  he 
will  not  withdraw  all  the  money  at  once  but  will  allow  part  of  it 
to  remain  on  deposit,  to  be  withdrawn  week  by  week  as  occasion 
may  demand.  The  note  for  the  whole  amount  of  the  loan  is  dis- 
counted and  the  interest  amounting  to  $180  is  deducted  in  ad- 
vance. When  the  loan  is  made  the  borrower  takes  $5,000  in  cash 
and  leaves  the  balance  to  his  credit  ($i8,ooo-$i8o-$5,ooo)  on 
deposit.  This  increases  the  deposit  account  by  $12,820.  The 
new  statement  is  as  follows : 


Resources 

Loans  and  discounts $37,000 

Banking  house,  furniture, 

and  fixtures 1 5>ooo 

Securities,     stocks,     and 

bonds 6,000 

Due  from  other  banks 1 5,000 

Cash 45,090 

$118,090 


Liabilities 

Capital 

Interest  and  discount  col- 
lected   or    credited    in 
advance  of  maturity  but 
not  earned  (approximate) 
Deposits 


5 1 00,000 


270 
17,820 

$118,090 


A  depositor  next  asks  for  a  New  York  draft  of  $500.  The  bank 
draws  a  draft  on  the  New  York  bank  with  which  it  has  a  deposit, 
and  when  this  is  presented  for  payment  the  statement  reads 
(if  no  charge  is  made  for  drawing  the  draft) : 


IX 


THE  BALANCE  SHEET  OF  A  BANK 


131 


H 

Liabilities 

$37,000      Capital $100,000 

Interest   and   discount    col- 
15,000          lected  or  credited  in  ad- 
6,000           vance  of  maturity  but  not 
14,500          earned  (approximate) ....  270 

Cash 45,090      Deposits 17,320 


Resources 

Loans  and  discounts 

Banking    house,    furniture, 

and  fixtures 

Securities,  stocks,  and  bonds 
Due  from  other  banks 


$117,590 


$117,590 


The  bank  receives  from  its  depositors  $3,000  in  checks  drawn 
on  other  banks  and  $1,200  in  cash.  Deposits  will  be  increased 
$4,200,  and  under  resources  will  appear  "checks"  or  "exchanges 
for  clearing  house."    The  balance  sheet  reads: 


Resources 

Loans  and  discounts $37,000 

Banking    house,     furniture, 

and  fixtures 15,000 

Securities,  stocks,  and  bonds  6,000 

Due  from  other  banks 14,500 

Exchanges      for      clearing 

house 3,000 

Cash 46,290 

$121,790 


Liabilities 

Capital $100,000 

Interest  and  discount  col- 
lected or  credited  in  ad- 
vance of  maturity  but  not 
earned  (approximate) ....  270 

Deposits 21,520 


$121,790 


Again,  the  bank  certifies  a  check  for  $1,000  for  a  customer; 
the  deposit  account  is  reduced  by  that  amount,  and  a  new  lia- 
bihty,  "certified  checks,"  is  introduced,  making  the  statement: 


Resources 
Loans  and  discounts. .  . . 


J 


Liabilities 


7,000      Capital $100,000 


Banking    house,    furniture, 

fixtures 15,000 

Securities,  stocks,  and  bonds  6,000 

Due  from  other  banks 14,500 

Exchanges      for      clearing 

house 3,000 

Cash 46,290 

$121,790 


Interest  and  discount  col- 
lected or  credited  in  ad- 
vance of  maturity  but  not 
earned  (approximate).  ...  270 

Deposits 20,520 

Certified  checks 1,000 

$121,790 


132 


BANKING  AND  CREDIT 


[IX 


Instead  of  certifying  a  customer's  check,  the  bank  may  issue 
a  cashier's  check.  If  this  be  paid  for  with  cash  instead  of  with  a 
check  on  the  bank,  the  deposits  item  will  remain  unchanged,  and 
cash  on  the  resources  side  will  be  accordingly  increased. 

3.  Adjustment  Accounts. — The  bank  thus  continues  its  opera- 
tions— making  loans,  foreclosing  on  property  when  loans  are  not 
paid,  investing  in  securities,  depositing  in  other  banks,  receiving 
deposits  from  other  banks  and  from  individuals,  enlarging  its 
business  quarters,  receiving  checks  from  depositors,  and  obtaining 
payment  thereon  from  the  banks  on  which  they  are  drawn.  It 
is  also  necessary  as  time  passes  to  make  adjustments  to  take  care 
of  interest  and  discount  actually  earned.  To  be  more  exact,  the 
bank  transfers  daily  a  portion  of  the  item,  "Interest  and  discount 
collected  or  credited  in  advance  of  maturity  but  not  earned 
(approximate),"  to  the  undivided  profits  account.  In  the  same 
way  there  is  set  up  on  the  assets  side  "Interest  earned  but  not 
collected  (approximate) "  on  notes  and  bills  receivable,  which  item 
is  offset  on  the  liabilities  side  by  increasing  undivided  profits  the 
same  amount.  As  a  result  of  such  operations  the  balance  sheet 
finally  reads: 

K 


Resources 

Liabilities 

Loans  and  discounts . 

^1,031,786.72 

Capital 

$100,000.00 

Securities,  stocks,  and 

Undivided  profits .... 

15,678.00 

bonds 

197,000.00 

Interest  and  discount 

Interest    earned    but 

collected     or 

not    collected    (ap- 

credited in  advance 

proximate)  on  notes 

of  maturity  but  not 

and  bills  receivable. 

1,955-86 

earned     (approxi- 

Banking house,  furni- 

mate)   

1,721.25 

ture,  and  fixtures .  . 

54,000.00 

Due  to  banks 

63,677-79 

Other  real  estate .... 

18,314.14 

Deposits 

1,446,912.65 

Due  from  banks 

258,296.23 

Certified  checks 

2,729.51 

Exchanges  for  clear- 

ing house 

1,476.78 

Cash 

67,889.47 
51,630,719.20 

$ 

i 

1,630,719.20 

IX]  THE  BALANCE  SHEET  OF  A  BANK  133 

4.  Surplus  Account  and  Dividend  Payment.— The  bank  now 
determines  to  set  aside  $10,000  for  a  surplus.  This  will  be  taken 
from  undivided  profits.  A  new  item  of  surplus,  $10,000,  will 
appear  under  liabilities.  In  illustration  of  the  significance  of  sur- 
plus, the  effect  on  the  statement  of  the  withdrawal  of  $10,000  in 
cash  by  depositors  may  be  considered.  The  withdrawal  would 
reduce  cash  on  the  assets  side  and  individual  deposits  on  the 
liabilities  side  by  the  same  amount;  surplus  would  thus  remain 
unchanged. 

The  directors  also  declare  a  semiannual  dividend  of  3  per  cent 
on  the  capital.  This  will  further  reduce  the  undivided  profits 
by$3,ooo.  Undivided  profits  will  then  read  $2,678.  When  the 
dividend  is  paid,  cash  will  be  diminished  $3,000.  If,  however,  the 
stockholders  deposit  the  dividend  checks  with  the  bank,  the  cash 
item  will  remain  undisturbed,  and  the  deposit  account  will  be 
increased.  If  the  stockholder  does  not  present  his  dividend  check 
for  payment  or  transfer  it  to  his  deposit  account ,  a  new  item  under 
liabiHties  may  appear,  "dividends  unpaid."  When  payments  are 
made  for  current  expenses,  as  for  salaries,  stationery,  postage 
and  express  charges,  the  cash  account,  on  the  one  side,  and 
the  undivided  profits  account,  on  the  other,  will  be  decreased 
by  that  amount.^ 

Again,  the  bank  may  subdivide  its  cash  into  the  different 
kinds  of  money  which  it  holds  and  it  also  may  classify  its 
deposits,  distinguishing  between  deposits  payable  on  demand 
and  those  payable  on  time. 

As  a  result  of  setting  aside  $10,000  from  undivided  profits 
into  surplus,  the  declaration  and  payment  of  a  cash  dividend, 
and  also  a  more  detailed  classification  of  resources  and  liabili- 
ties, the  balance  sheet  will  appear  as  shown  on  the  following 
page: 


■5  Current  expenses  do  not  affect  undivided  profits  directly.     They  are  debited  to  gross 
profits  before  net  profits  are  credited  to  the  undivided  profits  account. 


134 


BANKING  AND  CREDIT 


IX 


Resources 

Liabilities 

Loans  and  discounts .     $i 

,031,786.72 

Capital 

$100,000.00 

Securities,  stocks,  and 

bonds 

197,000.00 

Surplus 

10,000.00 

Interest    earned    but 

Undivided  profits 

2,678.00 

not    collected    (ap- 

Interest and  discount 

proximate)  on  notes 

collected  or  credited 

and  bills  receivable 

1,955-86 

in    advance    of 

Banking  house,  furni- 

maturity   but  not 

ture,  and  fixtures. . . 

54,000.00 

earned      (approxi- 

Other real  estate.  .  .  . 

18,314.14 

mate)  

1,721.25 

Due  from  banks 

258,296.23 

Due  to  banks 

63.67779 

Exchanges  for  clear- 

Individual    deposits 

ing  house 

1,476.78 

subject  to  check . . . 

1,215,435.66 

Cash: 

Demand    certificates 

Gold  coin 

2,459.00 

of  deposit 

130,000.00 

Silver  coin 

4,500.00 

Time    certificates   of 

Nickels  and  cents. . 

1,010.47 

deposit 

101,476.99 

National  bank  notes 

19,500.00 

Certified  checks 

2,729-51 

United  States  notes 

37,420.00 

$ 

$7 

,627,719.20 

1,627,719.20 

In  a  condensed  statement  the  last  four  items  under  liabilities 
are  frequently  grouped  under  a  heading  of  "deposits." 


5.  Other  Items. — Other  items  may  appear  on  the  balance 
sheet,  as,  for  example,  "overdrafts"  under  resources.  When  a 
depositor  overdraws  his  account,  the  amount  is  for  the  time  being 
considered  in  the  same  light  as  a  loan  by  the  bank.  Steps  are 
taken,  of  course,  to  secure  its  payment  and  as  a  rule  overdrafts 
are  quickly  liquidated.  If  finally  no  settlement  can  be  secured, 
it  will  be  marked  off  on  the  resources  side,  and  an  equal  amount 
will  be  deducted  from  undivided  profits,  as  a  loss. 

Checks  are  not  all  presented  through  the  clearing  house,  and 
a  classification  is,  therefore,  made  between:  (i)  exchanges  for 
clearing  house;  (2)  checks  on  other  banks  in  this  city;  and  (3) 
country  checks,  that  is,  checks  on  out-of-town  banks.  Securities 
are  further  distinguished  as  stocks,  bonds,  mortgages,  public 


IX]  THE  BALANCE  SHEET  OF  A  BANK  135 

securities,  etc. ;  and  if  the  bank  be  a  member  of  the  federal  reserve 
system  it  will  own  stock  of  the  federal  reserve  bank,  which  will  be 
separately  listed. 

Interest  which  has  accumulated  on  securities  but  is  not  yet 
due  may  be  entered  as  "accrued  interest,"  a  resource  not  yet 
converted  into  cash.  If  so,  the  amount  will  be  offset  under  lia- 
bihties  in  the  "undivided  profits." 

"  Customers'  liability  under  letters  of  credit"  on  the  resources 
side  and  "Letters  of  credit  and  travelers'  checks"  on  the  liabili- 
ties side  are  common  items  in  the  balance  sheet  of  a  large  com- 
mercial bank.  For  example,  a  bank  issues  a  commercial  letter  of 
credit,  thereby  agreeing  to  accept  drafts.  To  that  extent  it  has 
incurred  an  obligation  and  the  item  appears  under  liabilities .  The 
customer,  however,  is  under  obligation  to  furnish  the  bank  with 
funds  as  agreed  upon,  and  therefore  the  bank  has  a  corresponding 
resource.  Travelers'  checks  outstanding  are  liabiHties  which  the 
bank  will  be  required  to  honor  upon  presentment. 

A  bank's  liability  on  a  commercial  letter  of  credit  precedes 
that  on  acceptances  and  is  gradually  supplanted  by  the  latter. 
Against  both  is  the  asset,  customers'  liability,  first  on  the  letter 
of  credit  and  then  on  acceptances,  until  customers  reimburse  the 
bank  with  cash. 

The  changes  which  take  place  in  a  bank's  balance  sheet 
through  dealing  in  acceptances  may  be  illustrated  by  the  follow- 
ing operations : 

1.  The  bank  executes  $100,000  of  acceptances: 

Resources  Liabilities 

Customers'  liability  ac-  Acceptances     executed 

count  of  acceptances  for  customers -|-  $100,000 

executed  by  the  bank  -f  $100,000 

2.  If  the  bank  discounts  its  own  acceptances  of  $10,000  and 
pays  its  customer  in  cash  discount  amounting  to  $50,  the  changes 
will  be  as  follows : 


136 


BANKING  AND  CREDIT 


IX 


Resources 
Customers'    liability  ac- 
count  of   acceptances 
of  this  bank  purchased 

or  discounted 

Cash 

Customers'  liability  ac- 
count of  acceptances 
executed  by  this  bank 


-t-  $10,000 
-      9-950 


—     10,000 


Liabilities 
Interest  and  discount 
collected  or  credited 
in  advance  of  matur- 
ity but  not  earned. . . . 
Acceptances  of  this  bank 
purchased  or  dis- 
counted   


+ 


—     10,000 


It  will  be  observed  by  referring  to  the  balance  sheet  of  a  bank 
dealing  in  operations  concerned  with  letters  of  credit  and  accept- 
ances that  the  corresponding  entries  on  the  two  sides  are  nearly 
equal  in  amount.  The  reason  why  the  respective  entries  do  not 
exactly  agree  is  that  in  some  instances  the  letters  of  credit  and 
travelers'  checks  were  paid  for  when  originally  issued,  and  con- 
sequently the  bank  has  no  further  resource  in  these  transactions. 

In  the  case  of  acceptances  the  bank's  customer  in  whose  favor 
the  credit  has  been  opened  and  to  whom  the  bank  would  look  for 
funds  at  the  maturity  of  the  acceptance  not  infrequently  meets 
the  obligation  before  the  final  date  of  maturity,  in  which  case  he  is 
granted  a  discount  for  prepayment.  The  original  bill  may  be 
still  out  and  consequently  is  a  liability  which  will  eventually 
have  to  be  met. 


6.  Issue  of  Bank  Notes.— In  the  balance  sheet  thus  far  pre- 
sented the  item  of  bank  notes  issued  by  a  bank  has  not  yet  ap- 
peared as  a  liability.  Such  notes  will  be  issued  to  make  a  loan, 
to  pay  depositors,  to  purchase  securities,  or  for  other  investment. 
If  for  loans  or  investments,  there  will  be  anlacrease,  in  resources^ 
if  paid  out  to  meet  current  expenses,  there  will  be  an  equal  de- 
crease in  undivided  profits;  if  paid  to  depositors,  the  issue  of  notes 
and  decrease  in  deposits  will  offset  each  other.  The  issue  of  na- 
tional bank  notes  by  a  national  bank  is  accompanied  by  an  in- 
vestment in  United  States  bonds  and  until  the  passage  of  the  act 
of  1 913,  by  the  creation  of  a  5  per  cent  redemption  fund  deposited 


IX]  THE  BALANCE  SHEET  OF  A  BANK  I37 

with  the  United  States  Treasury.    The  bonds  and  the  redemption 
fund  alike  appear  on  the  resources  side. 

7.  Rediscounts. — With  the  estabHshment  of  the  federal  re- 
serve system  and  the  growing  practice  of  rediscounting  of  com- 
mercial paper  by  member  banks  at  the  federal  reserve  banks,  the 
item,  "rediscounts,  federal  reserve  bank,"  frequently  appears  on 
the  liability  side.  If  this  be  done,  "lawful  reserve"  on  the  re- 
sources side  will  be  increased.  '^  Some  banks  omit  the  item  among 
liabilities  and  reduce  the  loans  by  the  amount  of ' '  rediscounts,"  etc. 

8.  Statement  of  a  National  Bank. — In  the  statements  periodi- 
cally submitted  by  a  national  bank  to  the  Comptroller  of  the  Cur- 
rency, the  resources  and  liabilities  are  listed  in  great  detail.  Under 
resources  there  are  more  than  40  items,  and  under  liabilities 
nearly  as  many.  More  concisely  the  resources  may  be  classified 
as:  (i)  loans,  (2)  securities,  (3)  bank  premises,  (4)  cash,  (5)  credit 
instruments  in  process  of  liquidation  through  the  clearing  house 
or  other  agency,  and  (6)  deposits  in  other  banks.  The  principal 
liabilities  may  be  also  classified  as:  (i)  to  stockholders,  (2)  to 
depositors,  and  (3)  to  noteholders,  if  the  bank  issues  notes. 

For  purposes  of  illustration,  the  balance  sheet  of  a  national 
bank  in  a  city  of  approximately  25,000  inhabitants  is  presented. 
The  numbers  and  letters  which  appear  on  the  right  and  left  of  the 
statement  refer  to  the  numbers  of  the  items  on  the  standardized 
form  which  is  filled  out  on  the  Report  of  Condition  to  the  Comp- 
troller of  the  Currency.  As  this  bank  is  a  small  institution,  it 
does  not  carry  all  the  items  on  the  detailed  form,  but  the  principal 
resources  and  liabilities  are  included,  and  the  statement  is  applic- 
able to  all  national  banks  outside  of  the  metropolitan  cities. 

■•  The  entries  which  banks  usually  make  in  the  case  of  rediscounts,  properly  so-called 
(not  reserve  bank  advances),  are  as  follows:  At  time  of  rediscount,  "Rediscounts,  federal 
reserve  bank"  is  credited  for  face  amount  of  the  rediscounts  to  show  contingent  liability; 
the  offsetting  entry  is  twofold:  a  debit  to  the  unearned  discount  account  for  amount  of  the 
discount,  and  a  debit  to  "Lawful  reserve"  for  amount  of  proceeds.  Upon  maturity  of  the 
items,  "Rediscounts,  federal  reserve  bank,"  is  debited  to  cancel  "Contingent  liability  and 
loans,"  which,  so  far,  remained  unchanged.  In  the  balance  sheet  the  rediscounts  may 
appear  as  a  deduction  from  "loans"  instead  of  as  an  item  among  liabilities. 


138  BANKING  AND  CREDIT  [IX 


Victory  National  Bank 
Report  of  Condition  at  the  Close  of  Business  on  December  29, 1921 

Resources 

I  a  Loans  and  discounts,  including  re- 
discounts      $1,895,476.12 

Deduct: 
d  Notes  and  bills  rediscounted  with 
federal  reserve  bank  (other  than 
bank  acceptances  sold) 98,400.00     $1,797,076.12       i 


2       Overdrafts,  unsecured 324.22 

4       United  States  government  securities  owned : 
a       Deposited   to    secure   circulation 

(United  States  bonds  par  value)        $200,000.00 
c       Pledged  to  secure  postal  savings 

deposits  (par  value) i  ,000.00 

d       Pledged  as  collateral  for  state  or 

other  deposits  or  bills  payable.  205,860.93 

f       Owned  and  unpledged 50,488.40 

h       War  savings  certificates  and  thrift 

stamps  actually  owned 16.92 


Total  United  States  government  securities.  .  .  .  457,366.25       4 

Other  bonds,  securities,  etc. : 

Bonds  (other  than  United  States 

bonds)  pledged  to  secure  United 

States  deposits $8,982.50 

Bonds  (other  than  United  States 

bonds)  pledged  to  secure  postal 

savings  deposits 12,431.30 

Securities     other     than     United 

States    bonds     (not    including 

stocks)  owned  and  unpledged. . .  10,960.00 


Total  bonds,  securities,  etc.,  other  than  United 

States 32,373-80       5 

7  Stock  of  federal  reserve  bank  (50  per  cent  of  sub- 

scription)   

8  a  Value  of  banking  house  owned  and  unencumbered. .  . 

10  Real  estate  owned  other  than  banking  house 

1 1  Lawful  reserve  with  federal  reserve  bank 


13,500.00 

7 

92,927.56 

8 

11,100.00 

10 

68,016.50 

II 

IX]  THE  BALANCE  SHEET  OF  A  BANK  139 

13       Cash  in  vault  and  net  amounts  due  from  national 
banks: 

a       Cash $44,154.58 

b       Net  amounts  due  from   national 

banks 39-7I3-I7  83,867.75     13 


14  Net  amounts  due  from  banks,  bankers,  and  trust 
companies  in  United  States  (other  than  in  items 
II  or  13) 1,838.93     14 

16  Checks  on  other  banks  in  the  same  city  or  town  as 

reporting  bank 1,648.91      16 

17  Checks  on  banks  located  outside  of  city  or  town  of 

reporting  bank  and  other  cash  items: 

c        Internal  revenue  stamps $200.00 

d       Other  cash  items: 

Our  checks (a)   $60,944.83 

Cash  items (b)     12,622.17  73,567.00  73,767.00     17 


18  Redemption  fund  with  United  States  Treasurer ...  .  10,000.00     18 

19  Interest  earned  but  not  collected  (approximate)  on 

notes  and  bills  receivable  not  past  due 4,500.00     19 


>,748,307.04 


Liabilities 

21  Capital  stock  paid  in $200,000.00     21 

22  Surplus  fund 250,000.00     22 

23  a  Undivided  profits $195,718.80 

b  Less:  Current  expenses,  interest,  and 

taxes  paid 14,154.30  181,564.50     23 


24       Interest  and  discount  collected  or  credited  in  ad- 
vance of  maturity  and  not  earned  (approximate) . .  6,500.00     24 

27  Circulating  notes  outstanding 192,697.50     27 

28  Amount  due  to  federal  reserve  bank  (deferred  credits)  24,829.81     28 

30  Net  amounts  due  to  banks,  bankers,  and  trust  com- 

panies in  the  United  States  and  foreign  countries 

(other  than  included  in  item  28) 62,829.70     30 

31  Certified  checks  outstanding 16,482.26     31 

Total  of  items  28,  30,  and  31. . .  .         $104,141.77 
Demand  deposits  (other  than  bank  deposits)  sub- 
ject to  reserve  (deposits  payable  within  30  days): 

33  Individual  deposits  subject  to  check 1,546,145.47     33 

34  Certificates  of  deposit  due  in  less  than  30  days 

(other  than  for  money  borrowed) 78,846.55     34 


140  BANKING  AND  CREDIT  [IX 

37  Dividends  unpaid 18.00     37 

Total  (items  33,  34,  37) $1,625,010.02 

Time  deposits  subject  to  reserve  (payable  after  30 
days,  or  subject  to  30  days  or  more  notice,  and 
postal  savings) : 

41  Postal  savings  deposits 7,893.25     41 

48  Bills  payable  with  federal  reserve  bank 180,500.00     48 

Total  (items  41,  48) $188,393.25 


Total $2,748,307.04 

54  a  Liabilities  for  rediscounts,  with  federal  reserve  bank 

(See  item  i ,  d) 98,400.00     54 

This  detailed  statement  may  be  conveniently  condensed  to 
show  the  principal  classes  of  resources  and  liabilities: 

Resources 

Amount 

1.  Loans  (including  overdrafts) $1,797,400.34 

2.  Securities 503,240.05 

3.  Banking  house  and  real  estate 104,027.56 

4.  Cash,  deposits  in  other  banks,  reserve,  checks  on  other 

banks,  redemption  fund 339,i39-09 

5.  Adjustment  account,  interest  earned  but  not  collected.  .  .  .  4,500.00 


$2,748,307.04 


Liabilities 

1.  To  stockholders,  including  capital,  surplus,  and  undivided 

profits $631,564.50 

2.  To  depositors,  individual  and  banks,  bills  payable 1,917,545.04 

3.  To  noteholders 192,697.50 

4.  Adjustment  account,  interest  collected  but  not  earned 6,500.00 


$2,748,307.04 


References 

Dunbar,  C.  F.     Theory  and  History  of  Banking. 

Banking  operations  and  accounts,  pp.  22-42,  59-60,  64. 
Kniflfin,  W.  H.     The  Business  Man  and  His  Bank. 

How  to  read  a  bank  statement,  pp.  177-192. 
Moulton,  H.  G.,  Financial  Organization  of  Society. 

Analysis  of  commercial  banking  operations,  pp.  363-374. 


IX]  THE  BALANCE  SHEET  OF  A  BANK  14I 

Phillips,  C.  A.     Bank  Credit,     pp.  13-20. 
White,  H.     Money  and  Banking. 

Bank  statement,  pp.  205-215. 
Willis,  H.  P.     American  Banking,     pp.  177-184. 

and  Edwards,  G.  W.     Banking  and  Business,     pp.  173-184. 

Note:  See  Appendix  A,  Problem  17;  Appendix  B,  Problem  46. 


CHAPTER  X 

FUNDS  BELONGING  TO  STOCKHOLDERS 

1.  Capital  Stock. — In  analyzing  the  operations  and  services  of 
a  commercial  bank  there  is  an  advantage  in  considering  first  the 
items  which  represent  the  sources  of  financial  power.  As  indi- 
cated in  the  previous  chapter,  the  working  energy  of  a  national 
bank  is  derived  from  three  principal  sources;  stockholders,  deposi- 
tors, and  the  use  of  the  bank's  credit  in  the  form  of  bank  notes. 
This  chapter  will  consider  the  funds  belonging  to  the  shareholders. 

A  bank  begins  business  upon  the  capital  subscribed  by  its 
stockholders.  Federal  law  carefully  prescribes  the  minimum 
amount  for  the  operation  of  a  national  bank,  and  the  several 
states  likewise  have  regulations  of  this  nature  for  state  institu- 
tions. In  the  case  of  national  banks  the  minimum  amount  is 
based  upon  the  population  of  the  place  in  which  the  bank  is 
located.  In  towns  of  3,000  or  less  the  capital  must  be  at  least 
$25,000;  in  localities  with  a  population  of  3,000  to  6,000,  $50,000; 
with  a  population  of  6,000  to  50,000,  $100,000;  and  in  cities  over 
50,000,  «$20o,ooo.  One-half  of  the  capital  must  be  paid  in  before 
the  bank  begins  business,  and  the  remainder  within  six  months. 
Unlike  corporations  in  nearly  all  other  lines  of  business,  the  capi- 
tal of  a  bank  represents  the  paying  in  of  a  prescribed  amount  of 
actual  cash  as  a  condition  for  operation.  The  stock  is  issued  in 
shares  of  $100  par  value.  An  exception,  however,  is  permitted  in 
the  case  of  state  banks  which,  when  converted  into  national 
banks,  had  a  dift'erent  par.    But  few  banks  are  in  this  class. 

2.  Minimum  Capitalization  of  a  National  Bank. — Until  1900 
no  national  bank  could  be  organized  with  a  capital  of  less  than 
$50,000,  but  in  that  year  provision  was  made  for  the  smaller 

142 


X  1  FUNDS  BELONGING  TO  STOCKHOLDERS  1 43 

capitalization  of  $25,000.  The  object  of  the  earher  Hmitation 
was  to  prevent  so  far  as  possible  the  establishment  of  feeble  or- 
ganizations unequal  to  the  needs  of  the  community  in  which  the 
banks  were  located.  This  insistence  of  a  minimum  of  $50,000, 
however,  checked  unduly  the  creation  of  national  banks  in  small 
towns,  particularly  in  the  South  and  West,  where  there  was  not 
sufficient  business  to  justify  the  operation  of  a  banking  institution 
with  so  large  a  capital,  but  sufficient  to  warrant  the  successful 
operation  of  a  smaller  bank;  consequently  those  who  desired  to 
engage  in  the  banking  business  turned  to  a  state  charter  with  its 
less  stringent  rules  as  to  capitalization. 

The  change  in  1900  from  $50,000  to  $25,000  was  welcomed,  as 
is  shown  by  the  fact  that  between  that  year  and  1920  more  than 
half  (3,440)  of  the  new  national  banking  charters  were  granted  to 
institutions  with  a  capital  of  but  $25,000  each.  Most  of  these 
were  in  the  thinly  populated  sections  of  the  South  and  West; 
only  22  were  in  New  England. 

3.  Classification  of  National  Banks  According  to  Capital. — 

National  banks  were  grouped  ( 1 9 1 9)  as  to  their  capital  as  follows : ' 

Less  than  $50,000 2,612 

$50,000,  but  less  than  $100,000 2,415 

$100,000 I1364 

Over  $100,000,  but  less  than  $250,000 718 

$250,000,  but  less  than  $500,000 328 

$500,000,  but  less  than  $1 ,000,000 190 

$1,000,000,  but  less  than  $5,000,000 171 

$5,000,000  and  over 23 

Total 7,82 1 

Two-thirds  of  all  the  national  banks  have  but  a  modest  capi- 
talization— less  than  $100,000.  Such  a  system  of  a  large  number 
of  independent  units  of  capitalization  is  to  be  contrasted  with 
that  of  a  small  number  of  large  banks  with  branches  as  exists,  for 

'  Report  of  Comptroller  of  Currency,  1919,  Vol.  II,  p.  38. 


144  BANKING  AND  CREDIT  [X 

example,  in  Canada  and  in  European  countries.  As  a  national 
bank  cannot  loan  to  an  individual  customer  more  than  lo  per 
cent  of  its  capital  and  surplus,  it  is  obvious  that  a  bank  with  a 
small  capital  will  find  itself  restricted  in  providing  for  the  needs 
of  large  concerns. 

During  the  past  twenty  years,  in  order  to  meet  the  needs  of 
expanding  business  in  large  cities,  there  has  been  a  marked  tend- 
ency to  enlarge  the  capitalization  of  banks  already  established 
rather  than  to  organize  new  institutions.  Consequently  there 
have  been  consolidations  and  mergers  of  existing  banks,  resulting 
in  increased  capitalization  of  single  institutions.  The  banks  with 
a  capitalization  of  $5  million  and  over  were  located  in  1919  as 
follows : 

Boston 2  Chicago 2 

New  York  City 9  St.  Louis 2 

Philadelphia 2  Milwaukee i. 

Cincinnati I  Minneapolis i 

Detroit I  San  Francisco 2 

There  are  two  banks  in  New  York  City  which  each  have  a 
capital  of  $25  million.  The  largest  capitalization  in  Boston  is 
$10 million;  in  Chicago,  $2 1. 5  minion,andinSt.  Louis,  $10  million. 

4.  Capital  of  State  Banks. — State  banks  in  New  England 
and  the  more  eastern  middle  states  are  required  by  state  laws 
to  have  a  capital  of  at  least  $25,000.  In  most  of  the  other  states 
a  lower  capitalization  is  permitted;^  in  twelve  states  only  $10,000 
is  required  in  the  smaller  towns;  in  North  Carolina,  $5,000;  and 
in  Tennessee,  $7,500.-'  Requirements  as  to  capital  stock  of  trust 
companies  also  vary  in  different  states,  and  in  some,  gradations 
are  made  according  to  the  population  of  the  locality.  In  Massa- 
chusetts, for  example,  the  minimum  is  $100,000  for  cities  not 
greater  than  100,000  population;  for  others, not  less  than  $200,000.'* 

2  G.  E.  Barnett,  State  Banks  and  Trust  Companies,  pp.  39-40. 

■5  See  Provisions  ot  State  Laws  relating  to  Capital  Stock  and  Surplus  of  State  Banks  and 
Trust  Companies,  published  by  the  Federal  Reserve  Board,  June  1920. 
4  C.  Herrick,  Trust  Companies,  pp.  75-76. 


X]  FUNDS  BELONGING  TO  STOCKHOLDERS  145 

5.  Liability  of  Stockholders. — Shareholders  of  national  banks 
and  of  most  state  banks  are  liable  to  the  extent  of  the  amount  of 
their  stock  held  in  addition  to  the  amomit  invested  in  such  shares. 
This  is  known  as  "  double"  liability.  Here  again  is  seen  the  effort 
to  increase  the  responsibility  of  those  engaging  in  the  banking 
business  under  the  privileges  granted  by  the  government.  If 
there  are  insolvent  stockholders,  the  solvent  shareholders  are  not 
required  to  contribute  more  than  their  proportion  in  order  to 
make  good  the  deficiency. 

6.  Surplus. — Closely  allied  to  capital  stock  in  furnishing 
financial  support  is  surplus.  Surplus  is  created  either  by  original 
subscriptions  of  stockholders  in  addition  to  that  which  they  put 
in  as  capital,  or  is  built  up  out  of  earnings  which  are  not  distrib- 
uted in  dividends.  The  object  of  a  surplus  is  to  protect  the  bank 
against  unexpected  losses.  From  a  business  point  of  view  surplus 
exercises  the  same  function  as  capital.  Legally,  however,  there  is 
an  important  difference:  Although  stockholders  in  national  and 
in  many  state  banks  are  subject  to  a  double  liability  on  the  capital 
stock  which  they  may  hold,  they  are  not  subject  to  assessment 
upon  the  surplus. 

By  law  a  national  bank  must  create  a  surplus  of  20  per  cent, 
and  cannot  distribute  any  dividends  until  the  surplus  amounts  to 
10  per  cent  of  capital.  The  Victory  National  Bank,  whose  bal- 
ance sheet  is  given  on  pages  138-140,  has  a  surplus  larger  than  its 
capital  and  thus  far  in  excess  of  the  legal  requirement.  As  this 
bank  is  an  old  institution,  in  all  probability  the  surplus  has  been 
accumulated  out  of  past  earnings  or  profits  and  has  been  retained 
by  the  bank  in  order  to  strengthen  its  net  worth.  Some  new 
banks  create  a  surplus  by  subscription  before  beginning  business, 
for  the  sooner  the  surplus  is  created  the  freer  the  bank  is  to  dis- 
tribute its  earnings.  A  large  surplus  strengthens  the  working 
capital  and  tends  to  create  public  confidence.  On  the  other  hand, 
banks,  because  of  the  non-assessment  of  stockholders  according 


146 


BANKING  AND  CREDIT 


to  surplus,  are  open  to  the  suspicion  of  evading  responsibility  by 
building  up  surplus  and  keeping  capital  small.  In  some  instances 
capital  is  allowed  to  remain  low  because  of  state  laws  which  tax 
corporations  according  to  their  capital. 

In  1870  the  surplus  of  national  banks  was  but  a  little  above  the 
statutory  requirements,  22  per  cent  for  all  banks.  The  first 
marked  change  to  swell  the  surplus  took  place  between  1880  and 
1890,  and  was  due  largely  to  banks  in  New  York  City,  which 
allowed  their  capital  to  decrease  4  per  cent  and  doubled  their 
surplus.  Subsequently  banks  in  other  reserve  cities  followed  the 
policy  of  New  York  City.  The  following  table  shows  the  changes 
in  surplus  and  capital  stock  for  all  national  banks: 

Change  in  Surplus  and  Capital  Stock  of  National  Banks 


Years 

Per  Cent  of  Increase 
of  Surplus 

Per  Cent  of  Increase 
of  Capital 

1871-1880 

22 

2 

I 880-1 890 
I 890- I 900 

78 
21 

43 
3 

1900-1910 
1871-1919 

147 
561 

59 

125 

During  the  forty  years  1 871-19 10,  surplus  increased  more  than 
sixfold,  while  capital  stock  a  little  more  than  doubled. 

Many  states  follow  the  national  act  in  requiring  a  surplus  of 
20  per  cent.  Kansas,  Oklahoma,  and  Texas  go  farther  in  demand- 
ing the  accumulation  of  50  per  cent  of  capital  stock.  In  some 
states  the  creation  of  a  surplus  is  left  optional  with  the  bank.^ 
The  same  variation  is  found  in  the  state  statutory  requirements 
for  trust  companies.     As  Herrick  points  out,  however: 

The  accumulation  of  a  surplus  fund^  is  a  proceeding  that 
trust  companies  in  most  communities  adopt  as  a  matter  of  course, 


S  G.  E.  Barnett,  State  Banks  and  Trust  Companies,  pp.  S9-6o. 

*  It  is  to  be  noted  that  this  is  not  a  separate  fund  of  money ;  see  Appendix  A,  Problem  i8. 


X]  FUiNDS  BELONGING  TO  STOCKHOLDERS  147 

being  impelled  thereto  by  the  manifest  advantages  of  such  a  step 
as  a  measure  of  safety  and  as  a  means  of  gaining  business  in 
competition  with  other  companies  having  surplus  funds. 

7.  Undivided  Profits. — Undivided  profits  represents  earnings 
from  which  current  dividends  may  be  drawn,  but  many  banking 
institutions  which  are  seeking  to  add  to  their  surplus  permit  this 
item  to  accumulate  in  excess  of  the  dividend  requirements.  A 
considerable  part  of  undivided  profits,  therefore,  may  be  regarded 
as  capital  investment  not  yet  formally  dedicated  to  that  purpose. 
This  item  together  with  surplus,  if  examined  over  a  period  of 
years,  is  an  index  of  the  success  of  the  bank.  A  well-managed 
bank  rarely  distributes  all  of  its  undivided  profits  in  dividends, 
but  will  retain  a  portion,  both  to  increase  its  net  worth  and  as  a 
protection  against  possible  losses. 

8.  Comparison  of  Capital,  Surplus,  and  Undivided  Profits. — 

The  total  amount  of  capital,  surplus,  and  undivided  profits  in  all 
banking  institutions  in  the  United  States  in  191 9  was  as  follows: 

Capital,  Surplus,  and  Undivided  Profits  of  All  Banking 
Institutions 

(In  millions) 


Number 
of  Banks 

Capital 

Surplus 

Undivided 
Profits 

Total 

National  banks 

State  banks 

7.785 

17.225 

622 

1,097 

1 .377 
1 ,017 

$1,118.6 

785-7 

$872.2 

440.8 

333-4 

34-7 

491.9 
8.9 

$372.6 

164. 1 

65.0 

I3-I 

96.8 
4-7 

$2,363-4 
1,390.6 

398.4 
1 10.5 

1,039.1 
33-4 

Mutual  savings  banks 
Stock  savings  banks. . 
Loan  and  trust  com- 
panies   

Private  banks 

62.7 

450.4 
19.8 

Total 

29,123 

$2,437-2 

$2,181.9 

$716.3 

$.5,335-4 

148  BANKING  AND  CREDIT  [X 

It  will  be  observed  that  surplus  and  undivided  profits  com- 
bined amount  to  more  than  the  capital.  The  total  liabilities  of 
all  these  banking  institutions  amounted  to  over  $47  billion,  and 
the  liability  to  the  stockholders  constituted  about  one-ninth  of  this. 
In  the  balance  sheet  of  the  Victory  National  Bank  (pages  138- 
140),  which  has  been  selected  as  an  illustration  of  an  individual 
bank,  these  items  amount  to  $631,560,  or  nearly  one-fourth  of  the 
total  liabilities. 

In  recent  years  the  contribution  of  stockholders  (paid-in 
capital,  surplus,  and  undivided  profits)  has  not  kept  pace  with  the 
expansion  of  banking  business  as  seen  in  loans  and  deposits.  The 
largest  liability  of  a  bank  is  to  its  depositors.  For  many  years 
there  has  been  a  decline  in  the  ratio  of  capital  (including  surplus 
and  undivided  profits)  to  deposits,  and  some  believe  that  the 
amount  of  capital  should  be  regulated  by  its  deposits  as  well  as  by 
rules  of  population .  This  subject  will  receive  further  discussion  in 
the  chapter  on  deposits. 

9.  The   Banking  Business   as   Measured  by  Capital. — An 

interesting  study  might  be  made  of  tlie  part  which  banking  plays 
in  our  economic  life  as  compared  with  the  business  of  transporta- 
tion or  of  manufactures,  by  taking  as  a  measure  the  amount  of 
capital  invested.  Unfortunately  the  statistics  of  capitalization  of 
railways  and  of  manufacturing  establishments  are  not  compar- 
able, for  the  capital  as  reported  in  these  industries  has  not  neces- 
sarily been  paid  in.  In  many  instances  such  capital  is  fictitious, 
representing  simply  good- will,  franchises,  or  inflated  valuations 
The  capital  of  banks,  however,  represents  actual  money  which  has 
been  paid  into  this  form  of  enterprise.  Taking  the  figures  as  they 
stand,  in  191 5  the  total  capital  (including  surplus  and  undivided 
profits)  of  all  kinds  of  banks,  amounted  to  $4,538.7  million,  and 
of  railroads  (1914),  including  bonds,  to  $20,247  million,  or  omit- 
ting bonds,  to  $8,681  million.  In  manufactures  in  1909  the  capi- 
tal amounted  to  $18,428  million. 


X]  FUNDS  BELONGING  TO  STOCKHOLDERS  149 

References 

Phillips,  C.  A.     Bank  Credit,     pp.  22-30. 

Scott,  W.  A.     Money  and  Banking.     130-13 1. 

United  States.     Comptroller  of  the  Currency.    Annual  Reports. 

Gives  current  statistics  in  regard  to  capital,  surplus,  and  undivided 
profits. 
Westerfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  I,  pp.  84-86. 
Willis,  H.  P.     American  Banking,     pp.  147-152. 
and  Edwards,  G.  W.     Banking  and  Business,     pp.  62-65. 


CHAPTER  XI 

DEPOSITS 

I.  Source  of  Deposits. — Deposits  of  cash  or  credit  instruments, 
which  are  claims  for  cash,  are  made  by  individuals,  firms,  and 
corporations,  other  banks,  and  by  governmental  bodies.  The 
balance  sheet  of  a  bank  generally  expresses  the  deposits  of  other 
banks  under  the  term,  "due  to  banks,"  and  lists  the  deposits  of 
the  federal  government  under  "  United  States  deposits."  Depos- 
its constitute  by  far  the  larger  part  of  a  bank's  liabilities.  In 
general  the  relation  between  the  bank  and  its  depositors  is  not 
one  of  trusteeship  but  rather  that  of  debtor  and  creditor. 

Deposits  arise  in  two  ways:  first,  from  the  deposits  of  cash  or 
credit  instruments,  as  checks,  drafts,  and  bills  of  exchange;  and, 
second,  from  loans  which  the  bank  makes  to  the  individual  and 
which  are  left  on  deposit  to  his  credit.  The  creation  of  deposits 
out  of  loans  may  be  illustrated  as  follows:  A  borrower  wishes  to 
secure  a  loan  at  a  bank;  the  latter  can  grant  this  either  in  cash  or 
with  a  promise  to  pay  cash  or  its  equivalent  on  demand.  Ob- 
viously the  bank's  power  to  pay  actual  cash  is  limited,  and  con- 
sequently it  must  resort  to  such  substitutes  for  cash  as  will  satis- 
factorily serve  the  borrower  in  the  conduct  of  his  business.  If 
this  be  done  the  form  of  the  loan  is  immaterial.  The  loan  may 
be  made  by  giving  the  borrower  a  deposit  credit,  and  the  bor- 
rower, being  in  possession  of  a  deposit  account,  can  then  draw 
checks  upon  it.  In  so  far  as  the  borrower's  creditors  are  willing 
to  accept  checks  in  place  of  cash,  the  loan  renders  as  much  service 
as  if  actual  cash  were  advanced. 

2.  Nature  of  Bank  Loan. — In  saying  that  loans  make  deposits 
it  must  not  be  assumed  that  wealth  is  created  by  the  mere  process 

150 


XI]  DEPOSITS  151 

of  loaning.  There  is  In  existence  under  present  business  proce- 
dure an  enormous  volume  of  outstanding  credit  accounts  and 
other  forms  of  obligations  between  individuals.  By  loaning  upon 
these  claims  the  banks  convert  them  into  a  new  form  of  credit  or 
deposits,  so  as  to  make  them  more  readily  acceptable  and  facili- 
tate the  transaction  of  commerce  and  business.  Credit  is  back 
of  the  loan.  The  bank  converts  one  form  of  promise  to  pay  into 
another  form  of  obligation.  For  example,  John  Jones  in  the 
course  of  his  business  has  a  claim  against  Samuel  Smith.  Jones 
now  wishes  to  buy  material  from  x\ndrew  Adams ;  he  holds  Smith's 
promise  and  tenders  it  to  Adams  in  payment  for  the  material; 
Adams,  however,  is  averse  to  such  payment;  he  does  not  know 
Smith  and  declines  to  sell  his  goods  for  a  promise  which  he  is  not 
in  a  position  to  appraise  and  the  use  of  which  will  not  be  available 
in  his  own  business.  The  bank  undertakes  this  service.  Jones 
presents  the  claim  against  Smith  at  the  bank  and  on  the  strength 
of  this  applies  for  a  loan.  The  bank,  even  if  it  does  not  know 
Smith,  is  familiar  with  the  business  characteristics  and  integrity 
of  Jones,  who  must  hold  himself  liable  if  Smith  does  not  fulfil  his 
obhgation.  The  bank  consequently  makes  the  loan.  Jones  is 
then  in  possession  of  a  deposit  account  at  the  bank  and  can  draw 
checks  upon  this  account.  Adams  from  whom  he  buys  the 
material  has  now  no  hesitation  in  receiving  a  check  drawn  upon 
the  bank. 

The  bank  may  even  go  farther  and  grant  a  loan  simply  on  the 
promise  of  the  borrower,  unsupported  by  any  collateral  or  claims 
which  the  borrower  might  have  against  others.  In  this  case  as 
well  as  in  the  former,  deposits  represent  credits  created  in  advance 
of  liquidation  or  settlement  of  outstanding  indebtedness. 

3.  Bulk  of  Deposits  Arising  from  Loans. — Cash  itself  plays 
but  a  small  part  in  establishing  deposit  accounts  in  a  commercial 
bank — less  than  a  tenth  according  to  tests  which  the  office  of 
the  Comptroller  of  the  Currency  has  made  from  time  to  time. 


152 


BANKING  AND  CREDIT 


XI 


The  deposits  of  commercial  banks  are  largely  credits  and  not 
cash.  As  the  author  of  "The  Practical  Work  of  a  Bank"  ob- 
serves: *'  So  many  people  have  the  idea  that  the  bank  is  a  custo- 
dian— bailee — of  the  funds.  They  speak  of  having  so  much  money 
in  the  bank,  forgetting  that  they  have  nothing  in  the  bank,  but 
do  have  a  credit  on  its  books,  and  what  they  hold  is  an  'account 
payable'  of  the  bank."'  It  is,  however,  impossible  to  determine 
accurately  what  proportion  of  the  total  deposits  of  a  commercial 
bank  falls  in  each  of  the  two  classes  noted  above,  but  the  bulk  of 
deposits  arises  from  loans. 

The  close  dependency  of  deposits  (excluding  bank  deposits) 
to  loans  is  illustrated  by  comparing  the  amounts  of  each  at  differ- 
ent dates  for  all  national  banks  :^ 

Loans  and  Deposits  of  National  Banks 

(In  millions) 


Loans 

Deposits 

1890 
1900 
I9I0 

I9I9 

$  1,970.0 

2,687.0 

5.467.0 

11,010.2 

$  1.594 

2,602 

5.196 

12.940 

This  enormous  increase  in  deposits,  doubling  in  recent  dec- 
ades, is  not  due  to  an  increase  in  cash  entrusted  to  the  care  of 
the  banks,  but  to  the  increase  in  the  advances  of  credits  by  banks. 
The  figures  are  evidence  of  the  greater  use  of  credit  in  carrying 
on  the  business  of  the  country. 

The  ability  of  the  bank  to  meet  the  liability  incurred  by  the 
deposit  depends  not  merely  upon  the  cash  reserve  which  it  holds, 
but  to  a  much  greater  extent  upon  the  soundness  of  its  loans.  The 


'  W.  H.  Kniffin,  The  Practical  Work  of  a  Bank,  p.  62. 

^  Report  of  Comptroller  of  Currency,  1919,  Vol.  II,  pp.  754-756. 


XI]  DEPOSITS  153 

deposit  liability  as  a  whole  can  be  met  only  by  the  prompt  pay- 
ment of  the  loans.  A  loan,  indeed,  can  be  renewed  and  the 
deposit  continued,  but  if  this  practice  be  indulged  in  to  any  con- 
siderable extent  the  loan  resources  may  be  an  empty  asset  and  the 
deposit  liability  a  charge  which  cannot  be  met.  The  relation  of 
deposits  to  loans  and  reserves  is  discussed  more  fully  in  a  subse- 
quent chapter. 

4.  Deposit  Currency. — The  volume  of  deposits  which  is  sub- 
ject to  transfer  by  check  and  other  credit  instruments  furnishes 
what  is  called  "  deposit  currency."  To  a  large  extent  it  performs 
the  work  of  money  as  a  medium  of  exchange.  This  use  of 
deposits  as  currency  is  clearly  described  by  Dunbar: 

The  bank  deposit,  circulated  by  means  of  checks,  is  the  most 
convenient  medium  of  payment  yet  devised.  A  stroke  of  the  pen 
transfers  it  in  whatever  amount  is  needed  for  the  largest  transac- 
tions, and  this  transfer  instantly  becomes  the  basis  for  fresh  opera- 
tions, with  as  complete  security  against  accidental  loss  as  can  be 
imagined.  In  the  strict  economic  sense  this  medium  no  doubt 
has  rapidity  of  circulation  in  a  high  degree,  while  in  the  sense  of 
actual  activity  of  movement  in  a  given  time  it  far  outstrips  money 
or  notes,  and  has  been  well  said  to  be  the  most  volatile  of  all  the 
mediums  of  exchange.  Of  the  entire  circulating  medium  of  this 
country  it  forms  incomparably  the  greatest,  although  the  least 
considered,  part.  Depending  for  its  efficiency  solely  upon  con- 
version, it  for  the  most  part  eludes  the  regulations  which  legisla- 
tion so  industriously  enforces  upon  the  other  constituents  of  the 
currency.  Indeed,  beyond  the  requirement  of  a  minimum  re- 
serve made  by  the  law  of  the  United  States,  and  of  most  of  the 
several  states,  we  may  say  that  the  subject  is  not  touched  by  legis- 
lation, in  this  country  or  elsewhere.^ 

The  deposits  of  commercial  banks  constitute  an  enormous 
sum.  National  banks  held  in  1919  over  $10  billion  of  individual 
demand  deposits  subject  to  check,  as  well  as  over  $3  billion  of 


i  C.  F.  Dunbar,  The  Theory  and  History  of  Banking,  p.  51. 


154  BANKING  AND  CREDIT  [XI 

bank  and  United  States  deposits  which  could  be  checked  out  at 
will.  In  addition  there  were  $4  billion  of  deposits  subject  to 
check  without  notice  in  state  banks  and  over  a  billion  in  loan 
and  trust  companies.  There  were  also  several  billions  of  un- 
classified deposits  in  state  banks  and  trust  companies,  and  a  very 
considerable  amount  of  these  deposits  are  subject  to  check.  If 
these  combined  amounts  be  compared  with  an  estimate  of  the 
total  wealth  of  the  United  States,  say  $240  billion,  it  will  be  seen 
that  the  banks  have  temporarily  in  trust  a  very  considerable  part 
of  the  evidences  of  wealth  of  the  nation.  Comparison  of  de- 
posits with  the  volume  of  money  also  shows  how  small  a  part 
money  plays  in  the  deposit  operations  of  banks. 

5.  Limitations  of  Check  Currency. — Is  there  any  limit  to  the 
volume  of  check  currency?  The  volume  of  check  currency 
obviously  depends  not  only  upon  the  small  amount  of  actual 
cash  delivered  to  the  bank  for  deposit,  but  upon  loans  or  credits 
granted  by  the  bank  to  depositors,  and  to  the  deposit  of  checks 
and  other  credit  instruments  which  the  depositor  has  received 
from  his  debtors.  The  volume  of  credit  instruments  is  deter- 
mined by  the  volume  of  business  operations  in  process  of  settle- 
ment. Thus,  deposit  currency  fluctuates  with  the  amount  of 
business  enterprise  involving  the  services  of  banking  institutions 
in  the  granting  of  loans  or  credit.  The  only  practical  restriction 
placed  upon  the  possible  volume  of  deposit  currency  is  the  re- 
quirement of  a  cash  reserve  of  a  certain  percentage  of  the  deposits 
and  the  limitations  which  may  be  put  upon  loans. 

The  term  "volatile,"  as  apphed  by  Dunbar  to  deposit  cur- 
rency, is  well  chosen.  While  such  currency  in  the  mass  is  enor- 
mous and  is  expanding  with  the  growth  of  business  and  the 
consequent  increase  in  loans,  it  is  always  in  the  process  of  extinc- 
tion. The  loans  on  which  deposits  are  based  are  as  a  rule  short. 
The  deposit  perishes  when  the  loan  is  paid  by  check  drawn  on  the 
same  or  any  other  bank. 


XI J  DEPOSITS  155 

Theoretically  there  is  no  reason  why  deposit  currency,  or 
checks,  may  not  enter  into  general  circulation  in  the  same  way 
as  bank  notes.  The  bank  note  is  a  promise  to  pay,  created  by 
the  bank's  credit;  the  check  also  represents  an  implied  agreement 
or  promise  of  a  bank  to  pay  a  certain  sum.  If  a  depositor  should 
make  out  checks  on  carefully  prepared  paper,  payable  to  bearer^ 
and  in  convenient  denominations,  they  might  be  acceptable  for  a 
long  continued  series  of  payments.  A  check,  however,  is  not 
prepared  with  these  characteristics. 

There  is  not  general  and  sustained  confidence  in  the  checks 
issued  by  individuals;  it  is  more  convenient  to  draw  the  checks  in 
sums  which  satisfy  the  specific  obligation  to  be  met  rather  than 
in  even  denominations;  and  there  are  too  many  opportmiities  for 
imitating  and  altering  checks  issued  by  a  great  number  of  in- 
dividuals. Consequently  credit  instruments  of  this  nature  are 
promptly  redeemed  and  have  but  a  short  life.  A  check  is  quickly 
deposited  at  a  bank  and  upon  that  deposit  another  check  may 
be  drawn.  One  check  is  thus  replaced  by  another.  The  life  of 
the  individual  check  is  limited,  but  the  deposit  continues  to  cir- 
culate by  means  of  new  checks.  Some  checks  indeed  may  be 
used  in  successive  payments  by  indorsement,  but  as  a  whole, 
check  currency  is  speedily  liquidated.  Notwithstanding  the 
short  term  of  life  which  individual  checks  enjoy,  the  total  volume 
of  check  currency  outstanding  at  one  time,  as  has  been  previ- 
ously noted,  is  enormous,  and  it  is  by  means  of  this  agency  that  a 
large  number  of  business  transactions  are  settled. 

6.  Deposits  and  Capital. — Banking  business  tends  to  be  con- 
ducted more  and  more  upon  the  basis  of  deposits  rather  than 
upon  capital.  There  has  been  a  notable  change  in  the  relation 
of  deposit  liabiHties  to  the  capital  investment  of  banks.  In  1870, 
capital  (including  surplus  and  undivided  profits)  of  all  national 
banks  was  about  equal  to  deposits;  in  1919  the  ratio  of  capital  to 
individual  deposits  was  only  $1  to  $5.31.     In  some  individual 


156  BANKING  AND  CREDIT  [XI 

banks  the  ratio  of  capital  to  deposits  is  far  less,  and  many  believe 
that  the  stockholders  should  be  obliged  to  furnish  a  larger  pro- 
portion of  funds.  Such  critics  view  the  unlimited  expansion  of 
deposits  based  so  largely  upon  loans,  with  no  restriction  beyond 
the  maintenance  of  a  cash  reserve,  as  a  danger,  and  demand  that 
a  formal  restriction  be  placed  upon  the  total  deposits  which  an 
individual  bank  holds.  The  Comptroller  of  the  Currency  has 
recommended  that  this  relationship  of  capital  to  deposits  be 
definitely  prescribed  by  law,  so  that  the  total  deposits  which  a 
national  bank  may  receive  shall  be  limited  to  eight  or  ten  times 
the  unimpaired  capital  and  surplus  of  the  bank."*  It  is  argued 
that  inasmuch  as  loans  approximate  deposits,  if  deposits  are  ten 
times  the  capital  and  surplus,  a  loss  of  over  10  per  cent  in  loans 
through  bad  bebts  would  wipe  out  both  capital  and  surplus  and 
destroy  the  solvency  of  the  bank. 

7.  Time  and  Demand  Deposits. — Deposits  may  be  classified 
as  demand  deposits  or  time  deposits,  according  as  the  depositor  is 
free  to  withdraw  at  will  or  agrees  to  allow  the  deposit  to  remain 
for  a  minimum  specified  time.  Either  kind  of  deposit  may  or 
may  not  draw  interest,  depending  upon  the  previous  agreement. 
According  to  these  differences,  the  total  number  of  deposit 
accounts  in  all  national  banks  in  1919  was  classified  as  follows  i^ 

Demand  deposit  accounts  on  which  interest  is  allowed i  ,149,861 

Demand  deposit  accounts  on  which  no  interest  is  allowed ......  10,079,188 

Time  deposit  accounts  on  which  interest  is  allowed 6,765,179 

Time  deposit  accounts  on  whieh  no  interest  is  allowed 246,072 

18,240,300 

The  total  number  of  national  bank  deposit  accounts  alone 
makes  more  than  one-sixth  of  the  total  population,  but  in  many 
cases  one  depositor  has  more  than  one  bank  account,  in  the  same 

''  See  Report,  1914,  Vol.  I,  p.  20,  and  subsequent  reports;  also  E.  W.  Kemmerer,  The 
Relation  of  Bank  Capital  to  Deposits,  published  by  the  Bankers  Statistics  Corporation, 
1920. 

5  Report  of  the  Comptroller  of  the  Currency,  1919,  Vol.  I,  p.  32. 


XI]  DEPOSITS  157 

bank  or  in  different  banks.''  In  addition  there  are  the  deposit 
accounts  of  state  banks  and  trust  companies,  which  would  prob- 
ably add  several  million  more.  In  a  few  of  the  states  a  majority 
of  all  deposit  accounts  in  national  banks  are  carried  on  time,  as 
in  Maine,  Vermont,  Massachusetts,  Michigan,  Wisconsin,  and 
Minnesota.  In  Texas,  Louisiana,  Mississippi,  and  Oklahoma 
more  than  four-fifths  of  the  accounts  are  carried  on  demand. 

8.  Savings  Deposits. — In  addition  to  the  deposits  for  current 
use  to  be  checked  against  there  has  been  in  recent  years  a  growing 
tendency  for  commercial  banks,  as  well  as  the  more  specialized 
savings  institutions,  to  hold  deposits  of  savings.  The  table  in 
the  preceding  section  shows  that  more  than  one-third  of  the 
deposit  accounts  represent  time  deposits.  This  is  evidence  of 
the  large  participation  of  commercial  banks  in  holding  savings 
accounts.  There  is  no  authority  nor  prohibition  in  the  National 
Banking  Act  for  or  against  this  practice,  and  many  commercial 
banks  compete  with  savings  banks  for  this  business.  Beginning 
with  1908  each  national  bank  has  been  required  to  state  whether 
it  receives  savings  deposits,  and  if  so,  the  amount.^  In  the 
Federal  Reserve  Act  this  practice  of  carrying  savings  accounts  is 
recognized  by  the  requirement  that  member  banks  shall  be  re- 
quired to  keep  a  smaller  amount  of  reserve  against  its  time  de- 
posits than  against  demand  deposits.  This  act  also  defines  as 
demand  deposits  all  deposits  payable  within  t,o  days;  "time 
deposits  shall  comprise  all  deposits  payable  after  30  days,  and  all 
savings  accounts  and  certificates  of  deposit  which  are  not 
subject  to  less  than  30  days'  action  before  payment "  (section  19). 

Deposits  in  savings  banks  and  in  the  savings  departments  of 
commercial  banks  generally  are  not  based  upon  previous  loaning 
operations  but  represent  the  savings  of  the  depositors  who  prefer 
to  entrust  them  to  a  banking  institution  for  investment  rather 


*  Report  of  the  Comptroller  of  the  Currency,  1919.  Vol.  I,  p.  29. 

'  See  Report  of  the  Comptroller  of  the  Currency,  191 1,  pp.  27-30,  216-219;  also  Report, 
1912,  p.  II. 


158  BANKING  AND  CREDIT  1  XI 

than  to  undertake  individual  responsibility.  As  a  rule  deposits 
of  this  nature  are  not  checked  against,  and  frequently  the  savings 
banks  reserve  the  right  to  require  notice  in  advance  of  with- 
drawal, as  for  example,  30  days.  Although  this  right  is  rarely 
enforced,  there  is  a  tacit  assumption  that  withdrawals  will  be 
infrequent,  thus  leaving  the  bank  free  to  make  investments  of  a 
more  or  less  durable  nature,  as  in  mortgage  notes  and  bonds. 

9.  Cost  of  Checking  Accounts. — The  cost  to  the  bank  in 
carrying  small  deposit  accounts  against  which  checks  are  drawn 
is  frequently  overlooked.  A  banker  who  analyzed  the  accounts 
of  his  institution  found  that  there  were  4,636  small  checking 
accounts  with  an  average  balance  of  $30.  The  cost  of  handling 
these  small  accounts  over  the  income  from  them  was  about 
$26,000  annually.  Some  depositors  made  thirty  checks  in  draw- 
ing out  $100.  It  was  further  estimated  that  if  the  bank  could 
eliminate  these  4,600  accounts  the  remainder  of  the  25,000 
accounts  could  be  taken  care  of  with  about  one-third  of  the 
existing  force  of  employees.  Although  this  inquiry  was  made 
some  years  ago,  it  probably  illustrates  a  fairly  common  condition 
today. 

Many  of  these  accounts  arc  simply  household  accounts  where 
the  wife  deposits  fifty  dollars  the  first  of  the  month  and  then 
draws  this  out  in  checks  ranging  from  fifty  cents  to  $2.50.  Many 
of  the  accounts  belong  to  clerks  in  the  various  stores  whose  in- 
come is  from  $50  to  $60  a  month,  and  they  likewise  draw  a  great 
many  checks.  I  think  it  is  safe  to  say  that  of  our  52,000  accounts 
the  4,600  of  these  small  checking  accounts  cause  more  concern, 
more  worry,  and  more  trouble  than  all  the  rest  put  together. 

Another  writer  on  banking  states  that  accounts  with  bal- 
ances between  $50  and  $100  represent  a  loss  to  the  bank  of  $5.20 
to  $11.60  per  year.^  Some  banks  assume  this  loss,  calling  it 
good-will   advertising,   while   others,   because   of   the  expense, 


8  The  Bankers  Magazine,  Feb.  1921,  p.  217. 


XI]  DEPOSITS  159 

charge  the  depositor  a  small  sum.  Commercial  banks, because 
of  the  constant  fluctuations  in  their  deposits  due  to  withdrawals 
and  additions  by  checks,  are  obliged  to  employ  a  larger  number  of 
clerks  than  are  savings  banks  and  trust  companies.  On  this 
point  a  bank  official  made  the  following  analysis:  four  repre- 
sentative commercial  banks  in  Chicago,  with  deposits  of  $242 
million,  employed  1,319  officers  and  clerks;  four  savings  banks 
and  trust  companies  with  deposits  of  $168  million  had  only  360 
officers  and  clerks. 

Some  banks  require  a  minimum  of  deposit  before  an  account 
is  accepted.  For  example,  one  bank  in  New  York  requires 
$5,000,  others  demand  from  $100  to  $500,  and  some  country 
banks  require  only  $50.  Many  banks  now  make  a  small  service 
charge  for  carrying  small  accounts,  the  charge  varying  from  25 
cents  per  month  on  balances  less  than  $25,  to  $3  per  month  on 
balances  less  than  $100.  Deposit  accounts  are,  however,  sought 
for  by  banks,  not  simply  for  the  profit  which  may  be  derived  from 
the  balances  left  with  the  bank,  but  because  a  depositor  may  be- 
come a  borrower,  and  "it  is  an  axiom  of  banking  that  a  good 
borrower  is  as  much,  if  not  more,  benefit  than  a  good  depositor."' 

ID.  Interest  on  Deposits.- — For  many  years  there  has  been 
discussion  as  to  whether  national  banks  should  pay  interest  on 
deposits.  It  will  be  seen  from  the  table  on  page  156  that  but  a 
small  proportion  of  the  demand  deposit  accounts  receive  interest. 
Some  institutions  pay  a  small  rate,  2  per  cent,  onbalances  of  $100 
and  over,  up  to  a  minimum  balance  of  $25,000.  It  is  asserted 
that  commercial  banks,  if  interest  be  paid,  are  tempted  to  make 
unwise  investments  in  order  to  meet  this  outlay.  Moreover, 
under  such  policy  the  assets  are  more  likely  to  be  tied  up  through 
an  overextension  of  loans  or  purchase  of  securities,  so  that  in  case 
of  emergency  a  bank  is  not  in  a  position  to  meet  the  needs  of 
depositors.     Commercial  banking  is  not  primarily  designed  to 

9  W.  H.  Kniffin,  The  Practical  Work  of  a  Bank,  p.  59. 


l60  BANKING  AND  CREDIT  [  XI 

take  care  of  deposit  savings  but  to  facilitate  applications  for 
credit.  In  recent  years  the  Comptroller  of  the  Currency  has 
recommended  that  the  rate  of  interest  which  a  national  bank 
may  pay  shall  not  exceed  4  per  cent,  unless  the  highest  rate  of 
time  paper  fixed  by  the  federal  reserve  bank  of  the  district  is  in 
excess  of  that  rate. 

II.  Deposits  of  Banks  in  Other  Banks. — A  very  considerable 
portion  of  bank  deposits,  that  is,  deposits  made  by  one  bank  with 
another,  are  held  by  New  York  banks.  For  example,  at  the  close 
of  1 91 8  the  total  bank  deposits  held  by  all  national  banks  were 
$2,852  million.  Of  this  more  than  a  third,  or  $1,021  million,  was 
in  New  York  City  national  banks;  Chicago  banks  had  $318  mil- 
lion and  Philadelphia,  $172  million.  New  York  banks  hold 
deposits  from  every  section  including  foreign  countries  as  is  seen 
in  the  following  table  (December  31,  1918):"' 

Thousands 

From  banks  in  New  England  states $  55,070 

"  Eastern  states 388,621 

' '  Southern  states 112,182 

"  Middle  Western  states 168,327 

"  Western  states 38,047 

"  Pacific  states 52 ,733 

"  Alaska,  Islands,  and  foreign  countries 206,230 

These  large  bank  deposits  in  New  York  City  and  other  finan- 
cial centers  are  due,  first,  to  the  need  of  "country"  banks  carry- 
ing balances  in  these  cities  against  which  drafts  can  be  drawn 
for  the  convenience  of  their  customers;  and  second,  to  the  more 
profitable  use  of  surplus  funds  in  the  call  money  market,  particu- 
larly in  New  York  City.  Banks  in  the  metropolitan  centers  are 
willing  to  pay  interest  on  bank  balances  which  are  subject  to 
recall  on  demand,  because  they  in  turn  can  loan  these  funds  on 
demand  to  stock-brokers  and  others  engaged  in  stock  market 
operations. 

'"  Report  of  the  Comptroller  of  the  Currency.  1919,  Vol.  I,  pp.  86-89. 


XI]  DEPOSITS  l6l 

There  has  also  been  controversy  in  regard  to  the  policy  of 
paying  interest  on  bank  deposits.  In  the  larger  cities  it  has  long 
been  the  practice  of  banks  to  pay  interest  on  balances  of  other 
banks.  In  criticism  it  is  urged  that  this  attracts  funds  which 
would  otherwise  be  loaned  at  home,  that  interest  rates  are  there- 
by increased,  and  that  it  is  dangerous  to  tie  up  the  fortunes  of 
smaller  banks  and  their  depositors  with  the  operations  of  specu- 
lators in  New  York.  While  it  is  recognized  that  country  banks 
may  become  dependent  upon  the  banks  of  New  York,  Congress 
hesitates  to  place  legislative  restrictions  upon  the  free  movement 
of  funds.  After  the  establishment  of  the  federal  reserve  system 
the  rate  paid  on  New  York  bank  deposits  was  for  a  time  by  agree- 
ment determined  by  a  sliding  scale  based  upon  the  90-day  federal 
reserve  bank  discount  rate.  This  tying-up  of  the  interest  rate 
on  bank  balances  with  the  discount  policy  of  the  federal  reserve 
banks  was  regarded  as  objectionable,  and  in  1920  a  conference 
of  bankers  recommended  that  no  rate  in  excess  of  2  1/4  per  cent 
be  paid  on  the  balances  of  banks  and  trust  companies." 

12.  Guaranty  of  Deposits. — For  many  years  there  has  from 
time  to  time  been  agitation,  particularly  in  the  West  where  bank 
failures  were  not  infrequent,  for  the  insurance  of  bank  deposits 
by  government  guaranty.  A  bill  was  introduced  into  Congress 
in  1905  providing  that  all  deposits  in  national  banks  made  in 
good  faith  by  persons  not  stockholders  or  officers  of  the  bank 
should  be  guaranteed  by  the  United  States  government,  and  in 
order  to  indemnify  the  government  against  loss  a  special  tax 
should  be  levied  on  all  deposits,  equal  to  i/io  per  cent.  The 
proposal  attracted  attention  but  did  not  result  in  federal  legisla- 
tion. Several  states,  however,  passed  laws  for  the  guaranty  of 
deposits,  as  Oklahoma  in  1907,  followed  by  Kansas,  Nebraska, 
Texas,  South  Dakota,  North  Dakota,  Mississippi,  and  Washing- 


"  Federal  Reserve  Bulletin,  Feb.  1920,  p.  157. 


l62  BANKING  AND  CREDIT  [  XI 

ton. '  ^  An  effort  was  made  by  Oklahoma  to  apply  the  guaranty  to 
national  banks,  but  this  was  declared  unconstitutional.  It  is  diffi- 
cult to  determine  the  benefit  secured  by  this  legislation.  Banking 
in  some  of  these  states  at  least,  if  not  in  all,  had  been  inadequately 
supervised  by  state  authorities,  and  as  a  result  there  were  many 
weak  institutions.  The  guaranty  law,  with  the  possibility  of  as- 
sessment upon  all  banks,  forced  the  strong  banks  in  self-interest 
to  support  more  vigorous  supervision.  Failures  of  banks  conse- 
quently were  not  so  frequent.  It  is  claimed,  however,  that  this 
improvement  would  have  taken  place  even  if  there  were  no  guar- 
anty law,  for  failures  are  more  common  in  newly  settled  communi- 
ties and  are  not  so  likely  to  occur  when  the  pioneer  stage  is  passed. 

13.  Proposed  Guaranty  of  National  Bank  Deposits. — More 

recently  a  Comptroller  of  the  Currency  has  repeatedly  recom- 
mended that  bona  fide  deposits  of  national  banks  be  guaranteed 
when  an  individual  deposit  does  not  exceed  $5, 000  and  the  interest 
paid  is  not  in  excess  of  3  per  cent.  The  recommendation,  how- 
ever, proposes  that  the  acceptance  of  this  policy  shall  be  dis- 
cretionary with  each  bank  and  not  made  compulsory.  In  support 
of  this  proposal  it  is  argued  that  such  a  guaranty  would  afford 
security  to  millions  of  depositors;  that  a  large  amount  of  money 
now  hoarded  would  be  deposited  in  banks;  that  runs  upon  banks, 
with  attendant  disturbances  and  even  panics,  would  be  pre- 
vented; and  that  such  a  measure  would  contribute  to  the  unifica- 
tion of  the  banking  system. 

The  principal  objections  to  this  change  are  that  it  would  tend 
to  promote  lax  management  on  the  part  of  banks  making  risky 
and  unsound  loans.  Strong  and  conservative  banks  should  not 
be  called  upon  to  pay  for  the  mistakes  of  poorly  managed  in- 
stitutions. Moreover,  in  the  long  run  these  assessments  would 
finally  fall  upon  the  customers  of  the  strong  banks;  this  expense 

'^  For  description  of  this  legislation,  see  Thornton  Cooke,  "The  Insurance  of  Bank  De- 
posits intheWest,"  Qi'orterly  Journal  of  Economics,  Xov.  i  peg;  also  by  same  author,  "  Four 
More  Years  of  Deposit  Guaranty,"  Quarterly  Journal  of  Economics,  Nov.  1913. 


XI]  DEPOSITS  163 

would  decrease  the  service  which  they  could  render  to  their  own 
depositors.  It  is  also  urged  that  this  is  not  a  proper  field  for 
applying  the  principle  of  insurance,  and  that  the  analogies  drawn 
from  life  and  fire  insurance  are  irrelevant.  Death  is  a  risk  which 
overtakes  everyone,  and  fire  is  likely  to  injure  those  who  protect 
their  property  by  all  known  safeguards.  The  risk  of  failure  of  a 
well-managed  bank  is  practically  nil,  and  for  that  reason  each 
bank  should  stand  on  its  own  feet  and  not  be  made  responsible 
for  the  errors  of  weak  competitors. 

Many,  however,  believe  that  the  amount  of  hoarding  through- 
out the  United  States  is  enormous.  Although  the  ratio  of  losses 
to  deposits  in  the  aggregate  is  small  (but  a  fraction  of  i  per  cent) 
the  individual  depositor  is  not  protected  by  this  knowledge.  A 
single  bank  may  fail  and  its  depositors  lose  their  savings  or 
claims.  It  is  therefore  urged  that  in  spite  of  the  obligations  which 
have  been  named  social  policy  demands  that  the  risk  of  individual 
loss  be  removed  by  co-operative  effort.  The  establishment  of 
the  postal  savings  system,  whereby  deposits  in  small  amounts 
are  cared  for  by  federal  agencies,  has  done  much  to  reassure  the 
timid  and  ignorant  and  its  development  will  undoubtedly  check 
the  practice  of  hoarding. 

References 

Agger,  E.  E.     Organized  Banking,     pp.  19-23. 
Fiske,  A.  K.     The  Modern  Bank.     pp.  60—72. 
Holdsworth,  J.  T.     Money  and  Banking,     pp.  199-211. 
KnifiSn,  W.  H.     The  Practical  Work  of  a  Bank.     pp.  58-87. 

A  technical  description  of  the  deposit  process  and  of  the  work  of  the 
receiving  teller. 
Robb,  T.  P.     The  Guaranty  of  Bank  Deposits. 
United  States.     Comptroller  of  the  Currency.     Annual  Reports. 

Current  statistics. 
Westerfield,  R.  B.     Principles  and  Practice  of  Banking. 

Guaranty  of  deposits,  Vol.  I,  pp.  73-82,  130-144. 
Willis,  H.  P.     American  Banking,     pp.  51-63. 
and  Edwards,  G.  W.     Banking  and  Business,     pp.  96-105. 


CHAPTER   XII 
NATIONAL   BANK   NOTE   CIRCULATION 

1.  Nature  of  Bank  Notes. — A  bank  note  represents  the 
promise  of  a  bank  to  pay  the  holder  of  the  note,  when  presented 
for  redemption,  an  equal  amount  of  lawful  money.  The  holder 
of  the  note,  like  the  depositor,  has  a  claim  against  the  bank.  A 
customer  of  a  bank  can  take  the  proceeds  of  a  loan  or  claim  against 
the  bank  in  legal  tender  money,  or  in  a  deposit  against  which  he 
draws  checks,  or  in  bank  promises  which  the  bank  issues  in  the 
form  of  notes.  The  customer  sometimes  prefers  cash  and  some- 
times a  deposit  credit;  if  cash,  it  is  generally  immaterial  to  the 
customer  whether  the  bank  tenders  him  coin  or  its  certificate 
representative,  or  its  own  notes  of  issue,  provided,  of  course,  that 
the  credit  of  the  bank  be  good.  As  the  bank  notes  are  payable  to 
bearer  and  are  issued  in  familiar  and  convenient  denominations, 
they  are  as  serviceable  as  coin  or  government  promissory  notes 
in  the  ordinary  transactions  of  trade. 

2.  Bank  Notes  Compared  with  Deposit  Currency .^ — In  some 
respects  the  bank  note  is  not  as  convenient  as  the  deposit  credit. 
That  disadvantage  is  thus  described  by  Dunbar: 

The  deposit  transferred  by  check  is  more  convenient  for  hirge 
transactions  than  the  note,  being  more  expeditious  and  safer. 
The  safety  of  the  deposit  is  due  to  the  fact  that  the  check,  being 
usually  payable  "  to  order,  "  especially  when  the  amount  is  con- 
siderable, cannot  be  drawn  or  credited  to  its  holder  unless  en- 
dorsed by  the  payee.  If  lost  or  stolen,  therefore,  it  cannot  be 
paid  unless  the  bank  is  deceived  by  a  forged  endorsement,  in 
which  case  the  loss  falls  upon  the  bank  itself.  Bank  notes,  how- 
ever, being  payable  to  bearer  are  nearly  as  difficult  to  trace  as 
money.  • 


'  C.  F.  Dunbar,  Theory  ^nd  History  of  Banking,  p.  62. 

164 


XII J  NATIONAL  BANK  NOTE  CIRCULATION  165 

In  the  United  States  there  are  at  present  three  varieties  of 
bank  notes  in  current  use:  national  bank  notes,  federal  reserve 
notes,  and  federal  reserve  bank  notes.  Only,  the  first  of  these 
will  be  considered  in  this  chapter. 

National  banks  are  not  compelled  to  take  out  circulation; 
there  are,  however,  but  few  which  do  not  issue  some  notes.  In 
the  larger  cities  with  clearing-house  facilities,  deposit  currency 
is  frequently  more  serviceable  than  bank  notes,  and  consequently 
banks  with  enormous  loan  and  deposit  accounts  may  have  com- 
paratively small  note  issues.  In  rural  communities  banks  have 
greater  need  of  notes,  which  provide  a  convenient  medium  of 
exchange.  Banks  in  small  towns  may  also  find  an  advertising 
benefit  and  prestige  in  the  issue  of  notes  which  carry  the  bank's 
name.  The  difference  in  the  policy  of  banks  in  large  cities  and 
in  small  towns  is  seen  by  a  comparison  of  circulation  with  de- 
posits. The  note  circulation  of  "country"  banks  is  11  per 
cent  of  the  deposits  of  these  banks,  while  the  note  circulation 
of  "  reserve  city "  banks  is  approximately  4  per  cent  of  their 
deposits. 

3.  Security  of  Note  Issues.— For  general  acceptability  it  is 
essential  that  the  notes  be  secured  by  a  pledge  of  collateral  or 
by  a  gold  reserve.  Sometimes  the  security  is  sought  for  by  the 
requirement  of  a  cash  reserve  in  the  vaults  of  the  bank  or  else- 
where, proportioned  to  the  amount  of  the  issue;  and  sometimes 
by  a  specific  pledge  of  certain  property  as  securities.  Banking 
systems  have  varied  in  the  degree  of  security  which  has  thus  been 
given  to  the  deposit  and  to  the  note.  There  may  be  a  common 
reserve  to  protect  both,  or  there  may  be  one  kind  of  reserve  for 
one  and  another  kind  for  the  other.  For  deposits  of  national 
banks  there  is  a  reserve  kept  with  the  federal  reserve  banks 
ranging  from  7  to  13  per  cent;  for  notes  there  must  be  a  cash 
reserve  of  5  per  cent  kept  with  the  Treasury  Department  in 
addition  to  a  pledge  of  government  bonds. 


I66  BANKING  AND  CREDIT  [XII 

National  bank  notes  thus  have  a  greater  security  than  de- 
posits, for  the  note  has  behind  it  not  only  a  small  amount  of  cash 
reserve  but  government  bonds  of  the  same  value.  Even  if  the 
bank  fails,  the  noteholder  is  amply  protected  unless  the  credit 
of  the  government  be  suddenly  assailed  to  an  extent  that  the 
bonds  pledged  could  not  be  marketed.  In  the  event  of  failure 
of  a  national  bank  the  noteholders  are  preferred  creditors,  for 
they  have  the  first  claim  to  the  government  bonds  which  are 
pledged  for  the  circulation  and  constitute  part  of  the  assets  of 
the  bank.  The  depositors  follow  in  order  of  preference;  they  are 
protected  by  the  remaining  assets  of  the  bank,  in  addition  to  an 
assessment  upon  the  stockholders  for  an  amount  equal  to  the 
subscribed  capital.  The  reason  for  the  preference  of  note- 
holders is  obvious.  Notes  have  a  wide  circulation;  they  are  re- 
ceived by  those  who  have  no  knowledge  as  to  the  management  of 
the  bank  which  issues  the  notes,  and  their  circulation  would  be 
impeded  if  there  was  not  complete  confidence  in  their  redemp- 
tion. The  depositor,  on  the  other  hand,  is  in  a  better  position 
to  form  a  judgment  in  regard  to  the  soundness  of  the  bank,  and 
his  relationship  to  the  bank  is  one  of  voluntary  choice.  He  must, 
therefore,  assume  a  greater  responsibility  than  the  noteholder. 

4.  Bank  Notes  and  Credit. — In  the  issue  of  bank  notes  it  is 
sometimes  said  that  a  bank  creates  credit.  This  requires  ex- 
planation. A  bank  converts  certain  forms  of  property  which  it 
possesses  into  new  forms  which  may  be  used  as  credit  instru- 
ments. Just  as  it  holds  deposits  which  can  be  used  as  deposit 
currency  (checks),  so  it  may  own  securities,  as  government 
bonds.  These  bonds  are  not  serviceable  for  loaning  to  borrowers, 
for  they  cannot  be  used  as  a  medium  of  exchange.  The  bank 
may,  however,  by  depositing  the  bonds  with  the  government, 
receive  in  exchange  bank  notes  in  even  and  suitable  denomina- 
tions which  borrowers  will  gladly  take.  Securities  have  thus 
been  converted  into  available  credit  instruments.     The  bank  is 


XII]  NATIONAL  BANK  NOTE  CIRCULATION  167 

the  agency  whereby  credit  is  made  active  rather  than  the  creator 
of  credit. 

5.  Origin  of  National  Bank  Notes. — One  of  the  principal 
objects  in  the  establishment  of  the  national  banking  system  in 
1863  was  to  provide  a  uniform  bank  note  currency  which  should 
supersede  the  notes  issued  by  state  institutions.  At  the  time  of 
the  Civil  War  state  bank  note  circulation  amounted  to  about 
$200,000,000.  The  credit  of  these  notes  varied  according  to  the 
reputation  and  standing  of  the  banks  organized  under  widely 
different  state  laws  and  with  varying  degrees  of  note  protection. 
In  some  states  the  currency  enjoyed  a  high  degree  of  credit  and 
had  a  wide  range  of  circulation;  in  others,  owing  to  lax  super- 
vision of  banks,  it  was  regarded  with  more  or  less  distrust  and 
frequently  accepted  only  at  a  discount.  The  confusion  arising 
from  the  attempted  disruption  of  the  Union  further  clouded  the 
credit  of  state  banks,  particularly  of  the  border  states  between 
the  North  and  the  South.  The  danger  of  non-redemption  of 
notes  as  well  as  from  counterfeiting  was  increased. 

There  were  about  7,000  different  kinds  of  notes  in  circulation 
issued  by  over  a  thousand  banks.  Over  3 ,000  varieties  of  altered 
notes  were  afloat,  1,700  varieties  of  spurious  notes,  and  over  800 
varieties  of  imitations,  making  more  than  5,500  varieties  of 
fraudulent  notes.  In  1862  less  than  a  fifth  of  the  banks  issued 
notes  which  had  not  been  altered  or  counterfeited.  In  only  a 
few  of  the  states  was  the  circulation  secured  by  any  special  or 
adequate  pledge  of  securities  or  funds.  In  some  states  no  assets 
were  set  aside  to  protect  the  noteholder  when  the  currency  was 
discredited.  Trade  was  consequently  handicapped  and  fre- 
quently bank  failures  occurred  entailing  losses  to  innocent  note- 
holders. 

Apart  from  the  desire  to  reform  the  currency,  it  was  expected 
that  a  market  could  be  made  for  the  sale  of  United  States  bonds 
by  requiring  the  new  national  banks  organized  under  the  act 


I68  BANKING  AND  CREDIT  [XII 

of  1863  to  pledge  government  securities  as  a  prerequisite  to  the 
issue  of  circulation.  The  act  consequently  provided  that  upon 
such  purchase  and  pledge,  notes  could  be  taken  out  to  the  extent 
of  90  per  cent  of  the  market  value  of  the  bonds,  but  not  exceeding 
90  per  cent  of  the  par  value.  In  the  first  act  (1863)  no  effort  was 
made  to  restrict  the  circulation  of  state  bank  notes,  but  this  was 
accomplished  in  1865  by  the  imposition  of  a  tax  of  10  per  cent  on 
their  issues. 

Although  the  notes  were  not  legal  tender,  provision  was  made 
for  their  redemption  by  the  requirement  (1874)  that  every  na- 
tional bank  should  keep  in  the  Treasury  Department  a  reserve, 
known  as  the  "redemption  fund,"  equal  to  5  per  cent  of  its  cir- 
culation. In  making  the  government  a  redemption  agency, 
public  confidence  in  the  notes  was  thereby  strengthened. 

6.  Inelasticity  of  National  Bank  Note  Circulation. — The  Na- 
tional Bank  Act  did  not  aim  to  make  the  circulation  elastic  or 
proportionate  to  the  requirements  of  commerce  and  industry. 
The  security  of  the  notes  and  the  needs  of  government  finance 
were  the  principal  purposes  to  be  attained.  In  the  chapter  on 
deposits  it  has  been  shown  that  deposit  currency  (checks)  is  con- 
stantly changing  in  volume,  that  it  expands  and  contracts  as 
deposits  increase  or  decrease,  and  that  as  a  large  part  of  deposits 
is  based  upon  loans  which  represent  business  activity,  deposit 
currency  varies  as  commercial  transactions  are  brisk  or  slack. 
It  was  also  seen  that  the  loans  which  give  rise  to  deposits  are 
generally  for  short  periods,  and  that  this  results  in  equally  quick 
liquidation  or  redemption  of  deposit  currency. 

National  bank  notes  represent  a  currency  based  upon  very 
long  loans.  If  the  pledges  which  are  behind  these  notes  are 
sound  and  inspire  public  confidence,  the  notes  will  be  generally 
acceptable  and  circulate  as  readily  as  coin  or  other  forms  of 
government  money.  Moreover,  if  the  pledged  security  upon 
which  the  notes  are  issued  have  a  distant  date  of  maturity,  the 


XII 1  NATIONAL  BANK  NOTE  CIRCULATION  169 

notes  may  have  a  long  lease  of  life.  Long  loans,  however,  do  not 
represent  current  commercial  needs;  they  are  made  as  advances 
to  governments  which  are  in  need  of  funds  in  excess  of  the  pro- 
ceeds of  taxation,  or  to  corporate  enterprises,  as  railroads,  for 
developing  projects  which  require  years  to  be  productive.  A 
bank  which  ties  up  its  resources  in  such  assets  has  to  that  extent 
parted  with  its  ability  to  liquidate  old  loans  and  make  new  ones. 
To  that  extent  neither  its  loaning  power  nor  its  note  circulation 
expands  or  contracts  in  accordance  with  current  commercial 
needs. 

For  example,  a  bank  issues  $100,000  of  notes  based  upon  the 
pledge  or  security  of  $100,000  United  States  bonds  due  in 
twenty  years.  Let  us  assume  that  at  the  purchase  of  the  bonds 
the  bank  gave  the  government  a  deposit  credit  of  $100,000. 
The  government  checks  against  this  deposit  and  the  checks  are 
honored  in  the  notes  of  the  bank.  As  the  receivers  of  the  notes 
have  complete  confidence  in  their  safeness,  no  effort  is  made  to 
redeem  them.  The  circulation  is  expanded  $100,000.  Under 
the  terms  of  the  loan  the  government  will  not  make  payment  to 
the  bank  until  the  end  of  twenty  years.  Not  until  the  bonds 
are  taken  out  of  pledge  will  there  be  a  contraction  of  the  cur- 
rency.^ The  circulation  of  national  banks  is  of  this  nature  and 
for  that  reason  is  inelastic. 

7.  Profit  on  Circulation. — In  the  issue  of  notes  based  upon 
the  ownership  and  pledge  of  government  bonds,  the  national 
banks  were  able  to  make  a  generous  profit,  provided  the  bonds 
could  be  purchased  on  favorable  terms.  A  bank  obtained  in- 
terest on  the  bonds  and  also  on  the  notes  taken  out.  This  ap- 
parent double  profit  was  subject  to  certain  deductions.  The 
bank  did  not  receive  notes  up  to  the  full  value  of  the  investment, 
it  ran  a  risk  in  a  possible  decline  in  the  market  value  of  the  bonds, 


^  Temporary  contraction  may  result  from  notes  being  presented  for  redemption  by 
other  banks  to  the  bank  of  issue. 


I70  BANKING  AND  CREDIT  [XII 

and  it  had  to  defray  certain  incidental  charges  for  plates,  agents' 
fees,  and  cost  of  redeeming  the  notes.  Moreover,  the  circulation 
was  subject  to  a  federal  tax  of  i  per  cent.  There  was  an  addi- 
tional burden  if  the  bonds  had  to  be  purchased  at  a  premium,  for 
in  that  case  the  bank  must  set  aside  each  year  from  its  earnings 
a  certain  amount  as  a  sinking  fund  to  extinguish  the  premium, 
as  the  bonds,  when  they  reached  maturity,  were  redeemed 
at  par. 

In  the  years  immediately  succeeding  the  Civil  War  these 
disadvantages  were  not  apparent.  There  was  an  abundance  of 
bonds  due  to  the  large  borrowings  of  the  government ;  the  rates 
of  interest  on  the  bonds  were  high,  and  bonds  could  be  purchased 
at  favorable  prices.  There  was  consequently  a  large  profit  to 
be  gained  by  taking  out  notes.  As  state  bank  issues  were  re- 
tired by  a  burdensome  tax,  the  national  bank  circulation  quickly 
expanded  until  in  187 1  it  exceeded  $300  million,  far  in  excess  of 
the  amount  that  had  previously  been  put  out  by  the  total 
number  of  state  banks. 

After  1880  the  national  debt  was  rapidly  reduced  by  the  ex- 
cess of  revenue  over  expenditure.  There  was  a  decline  in  the 
market  rate  of  interest  on  all  investments,  and  the  new  refunding 
bonds  issued  by  the  government  did  not  bear  as  high  a  rate  of 
interest  as  those  replaced.  The  price  of  the  old  outstanding 
bonds,  which  were  not  refunded  and  which  bore  high  rates  of 
interest,  rose  to  a  considerable  premium .  Under  these  conditions 
the  profit  to  be  gained  by  taking  out  circulation  was  not  so  at- 
tractive. Many  banks,  indeed,  found  it  profitable  to  sell  their 
bonds  to  take  advantage  of  the  high  prices.  Between  1882 
and  1891  the  volume  of  bank  notes  fell  from  $359  milhon  to 
$168  million. 

These  movements  are  illustrated  by  the  following  table  show- 
ing the  price  of  government  bonds,  the  amount  of  government 
bonds  available  for  purchase  by  national  banks,  and  the  amount 
of  circulation  outstanding: 


XII 


NATIONAL  BANK  NOTE  CIRCULATION 


171 


National  Bank  Circulation   Compared   with  Volume  of  United 

States  Bonds 


AveraKe  Price  of  Bonds 

Amount  of 
U.  S.  Bonds 

(Millions) 

Amount  of 

Bank  Notes 

(Millions) 

Percentage  of 

4  per  cent's 
of  1907 

4  per  cent's 
of  1925 

Bonds  Deposited 
for  Circulation 

1880 

106.32 

$1,775 

S324 

20.3 

1885 

122.28 

1,247 

287 

25.0 

1890 

122.74 

776 

129 

18.7 

1895 

1X2. 01 

121.53 

781 

180 

26.5 

1900 

115-15 

134-52 

1,023 

224 

27.8 

1905 

104.61 

132.36 

895 

435 

52.2 

The  small  amount  of  profit  to  be  obtained  by  taking  out 
circulation  is  illustrated  by  the  computation  furnished  by  the 
Comptroller  of  the  Currency  in  his  report  for  1895: 

Profit  on  National  Bank  Circulation,  on  the  Basis  of  $100,000 
Bonds  and  $qo,ooo  Circulation 


Items 


Market  price 

Receipts: 

Interest  at  6  per  cent  on  notes  issued 
Interest  on  bonds 

Total 

Expenses: 

Tax  of  I  per  cent  on  notes 

Cost  of  redemption 

Express  charges 

Plates '.  . 

Agents'  fees 

Sinking  fund  account  premium 

Total 

Net  receipts 

6  per  cent  on  cost  of  bonds 

Profit  on  circulation 


Old  4 
Per  Cent's 


1 1 1.48 


Ss.400.00 
d, 000. 00 


$9,400.00 


900.00 

45-00 

3-00 

7-50 

7.00 

686.60 


$1,649.10 

7,750.90 
6,689.02 


$1,061.88 


New  4 
Per  Cent's 


$5,400.00 
4,000.00 


$9,400.00 


900.00 

45-00 

3-00 

7-50 

7.00 

277.13 


$1,239.63 


8,160.37 
7,305.16 


Per  Cent's 


$5,400.00 
5,000.00 


$10,400.00 


900.00 

45-00 

3-00 

7-50 

7.00 

1.392.33 


$2,354-83 

8,045.17 
6,885.20 


$1,159.97 


172  BANKING  AND  CREDIT  f  XII 

The  loss  of  interest  on  the  5  per  cent  redemption  fund  is  not 
included,  since  the  amount  in  the  fund  is  counted  as  part  of  the 
bank's  reserve. 

In  1900  an  important  change  in  the  conditions  of  note  issue 
was  made.  National  banks  were  permitted  to  issue  up  to  the  par 
value  of  the  bonds,  instead  of  90  per  cent,  and  the  tax  on  circula- 
tion was  lowered  from  I  to  1/2  per  cent,  provided  the  pledged  secu- 
rities were  the  new  refunding  2  per  cent  bonds.  Authority  was 
also  given  for  the  establishment  of  banks  with  a  capitalization  as 
low  as  $25,000,  thus  extending  the  system  to  the  smaller  towns. 
Many  new  small  banks  took  out  circulation  and  those  already 
established  increased  their  note  issues.  Circulation  increased 
each  year;  in  1914  it  reached  $750  million.  In  1920  the  profit  on 
national  bank  note  circulation,  based  upon  a  deposit  of  $100,000 
United  States  bonds,  ranged  as  follows,  according  to  the  variety 
of  bond  deposited  and  prices  of  the  bonds: 

United  States  consols  of  1930,  Loan  of  1925,  and  Panama 

Canal  Loan $981  to  $1,036 

Four's  of  1925 1,117    "     1,454 

Two's  of  1916-1936 1,064    "     1,221 

8.  Volume  of  National  Bank  Note  Circulation. — It  is  one  of 

the  purposes  of  the  Federal  Reserve  Act  (1913)  to  do  away  with 
national  bank  note  circulation.  This  act  authorized  the  federal 
reserve  banks  to  purchase  over  a  period  of  years  from  the  na- 
tional banks  their  government  bonds.  This  would  automatically 
retire  the  national  bank  note  circulation.  Owing,  however,  to  the 
war,  which  created  unexpected  financial  obligations,  the  federal 
reserve  banks  have  not  been  able  to  carry  out  this  policy.  As  a 
result  the  circulation  is  still  large,  amounting  in  1920  to  nearly 
$700,000,000. 

The  volume  of  national  bank  circulation  compared  with  cap- 
ital of  national  banks,  total  liabilities  of  national  banks,  and 
money  in  circulation,  is  shown  in  the  following  condensed  table: 


XII] 


NATIONAL  BANK  NOTE  CIRCULATION 


173 


National  Bank  Circulation  Compared  with  Capital,  Total 
Liabilities,  and  Total  Money  in  Circulation 

(Amounts  in  millions) 


Per  Cent 

Per  Cent 

Per  Cent 

Year 
July  I 

National 
Bank 
Notes 

Capital 
Paid   in 

Total 
Liabilities 

Total 
Money  in 
Circulation 

National 

Bank 
Notes  of 
Capital 

National 

Bank 
Notes  of 
Liabilities 

National 

Bank  Notes 

of  Total 

Money 

1880 

$3^7 

5j.s6 

S2.035 

S973 

74 

16 

.54 

1890 

182 

635 

3.010 

1,429 

29 

6 

13 

1900 

300 

622 

4.944 

2,055 

48 

6 

15 

1910 

684 

990 

9.897 

3.102 

68 

7 

22 

1920 

696 

1.224 

22.198 

6.088 

3 

1 1 

This  table  shows  the  declining  importance  of  national  bank 
note  circulation  among  the  liabilities.  Deposit  currency  (as  the 
result  of  deposits),  on  the  other  hand,  increased.  Even  before 
the  establishment  of  the  federal  reserve  system  (1913)  the  pro- 
portion of  national  bank  note  circulation  in  the  total  volume  of 
money  in  circulation  had  fallen  from  about  a  third  in  1880  to  less 
than  a  quarter  in  19 10.  The  volume  of  national  bank  note  cur- 
rency is  limited  by  the  total  amount  of  bonds  outstanding  which 
are  designated  by  law  as  available  for  pledge  against  circulation. 
In  1920  this  amounted  to  about  $800  million.  National  banks 
own  nearly  all  of  these  bonds,  and  the  limit  of  this  form  of  cur- 
rency under  existing  law  is  practically  reached. 

References 

Dunbar,  C.  F.     History  and  Theory  of  Banking. 

Bank  notes,  pp.  59-74. 
Holdsworth,  J.  T.     Money  and  Banking,     pp.  46-51;  163-166;  344-346. 
Monetary  Commission  of  the  Indianapolis  Convention.     Report,  1898. 

Fluctuations  of   United   States  bond   prices  and   inelasticity  of 
national  bank  note  currency,  pp.  224-230. 
Moulton,  H.  G.     Financial  Organization  of  Society. 

Declining  importance  of  national  bank  note  issues,  p.  372. 


174  BANKING  AND  CREDIT  [XII 

Phillips,  C.  A.     Readings  in  Money  and  Banking. 

Extracts  from  various  writers  on  defects  of  bond-secured  currency, 
pp. 682-695. 
United  States.     Comptroller  of  the  Currency.     Report,  1920. 

Profit  on  national  bank  note  issues,  V^ol.  II,  pp.  37-38.     Similar 
calculations  may  be  found  in  previous  reports. 
Westerfield,  R.  B.   Banking  Principles  and  Practice.    Vol.  II,  pp.  336-349= 
Willis,  H.  P.     American  Banking,     pp.  85-97. 
and  Edwards,  G.  W.     Banking  and  Business,     pp.  408-412. 


CHAPTER  XIII 

COMMERCIAL   LOANS 

I.  Variety  of  Loans. — A  borrower  may  obtain  funds  for  cur- 
rent transactions  in  a  variety  of  ways,  which  may  be  classified  in 
this  manner : 

A.  As  to  maturity: 

1.  Demand  or  call  loans: 

(a)   Direct  loans  on  promissory  notes 

2.  Time: 

(a)  Discounted  paper 

B.  As  to  obligation  of  parties: 

1.  Single-name  paper — promissory  notes 

2.  Double  name: 

(a)  Accommodation  paper 

(b)  Discounted  notes  of  a  customer  (receivables) 

(c)  Acceptances: 

(i)  Bankers' 
(2)  Trade 

C.  As  to  collateral  security: 

1.  With  collateral  consisting  of : 

(a)  Listed  securities 

(b)  Unlisted  securities 

(c)  Bills  of  lading 

(d)  Warehouse  receipts 

(e)  Trust  receipts 

( f )  Bills  receivable 

(g)  Accounts  receivable 
(h)  Chattels 

(i )  Mortgages  on  real  estate 
( j )  Mortgages  on  farms 
(k)  Other  collateral 

2.  Without  collateral 

175 


176  BANKING  AND  CREDIT  f  XIII 

D.  As  to  agency  negotiating  loan: 

1.  Banks 

2.  Commercial  paper  brokers  or  dealers 

3.  Finance  companies,  discount  companies,  etc.  . 

4.  Acceptance  corporations 

5.  Other  business  firms 

6.  Individuals 

E.  As  to  use  of  proceeds: 

1 .  Financing  short-time  operations  in  producing,  purchasing,  carry- 

ing, or  marketing  goods  in  one  or  more  steps  of  the  process  of 
production,  manufacture  or  distribution 

2.  Carrying  or  trading  in  stocks,  bonds,  or  other  investment  securi- 

ties, except  bonds  and  notes  of  the  United  States  government 

3.  Carrying  or  trading  in  bonds  or  notes  of  United  States  govern- 

ment 

4.  Consumptive  purposes 

2.  Demand  or  Call  Loans. — Demand  loans,  known  also  as 
"call"  loans,  may  be  terminated  at  any  time  by  the  action  of 
either  party;  the  lender  may  require  immediate  payment  or  the 
borrower  may  make  payment  before  it  is  demanded.  In  the 
United  States  call  loans  are  for  the  most  part  used  by  traders 
on  the  stock  and  produce  exchanges  in  Wall  Street  and  are 
negotiated  on  collateral  security.  In  general,  a  bank  prefers  to 
make  call  loans  only  to  those  who  have  no  claim  upon  it  and  from 
whom  it  would  not  hesitate  to  demand  immediate  payment  at 
any  time.  In  recent  years  a  market  for  call  loans  based  upon 
acceptances  has  been  developed  in  New  York,  similar  to  the 
London  call  loan  market. 

Brokers  who  deal  extensively  in  call  loans  keep  in  touch  with 
their  banks  and  know  just  where  and  how  much  call  money  is 
available  and  at  what  interest  rate.  Upon  learning  the  daily 
clearing-house  results,  bank  officers  in  New  York  having  surplus 
funds  available  for  call  loans  inform  their  brokers  who  make  loans 
on  the  floor  of  the  exchange.     These  brokers  loan  the  money  to 


XIII I  COMMERCIAL  LOANS  177 

other  brokers  and  traders  and  inform  the  bank  of  the  names  of 
those  who  have  borrowed.  Brokers  may  be  employed  on  a  salary 
or  on  a  commission  basis,  but  there  is  no  recognized  standard 
rate  to  be  charged  for  placing  such  loans.  Nearly  all  the  larger 
financial  institutions  make  their  stock-exchange  loans  through 
brokers  who  divide  their  time  between  making  loans  and  deal- 
ing in  securities.  Stock-exchange  time  loans  are  handled  by  a 
different  group  of  loan  brokers  who  go  from  bank  to  bank  with 
their  offerings. 

Although  by  agreernent  a  stock-exchange  call  loan  is  payable 
at  any  time  during  banking  hours,  it  is  customary  to  consider  a 
loan  as  running  for  at  least  one  day.  It  is  also  the  custom  of  the 
Street  not  to  demand  payment  on  Saturday.  In  calling  a  loan 
the  bank  sends  a  notice  to  the  borrower  before  12:15  p.m.  and  he 
then  has  until  2:15  p.m.  to  pay  his  loan  and  thereby  obtain  his 
collateral.  Technically  a  bank  may  call  for  additional  margin 
at  any  time,  and  if  such  margin  is  not  furnished  promptly  it  may 
sell  the  collateral,  reimburse  itself,  and  credit  the  balance,  if  any 
is  left,  to  the  borrower.  In  practice,  under  normal  market  con- 
ditions, margin  calls  are  sent  out  at  the  close  of  banking  hours 
and  the  broker  is  required  to  restore  his  margin  the  next  day. 
Brokers  generally  restore  their  margins  promptly  and  it  is  rarely 
necessary  to  call  a  loan  on  account  of  insufficient  margin. 

3.  Commercial  Call  Loans. — It  is  not  to  be  assumed  from  the 
foregoing  that  the  ordinary  mercantile  or  manufacturing  firm 
does  not  find  it  convenient  to  borrow  money  on  demand  loans. 
Very  often  a  bank  will  be  requested  to  accommodate  a  customer 
who  wishes  to  engage  in  some  new  undertaking  but  who  cannot 
determine  in  advance  just  when  the  transaction  will  be  com- 
pleted and  the  obligation  settled.  It  is  not  unusual  for  loans  of 
this  kind  to  run  for  6  months  or  a  year  or  even  longer.  There  is 
usually  a  mutual  understanding  (not  a  written  agreement)  be- 
tween the  bank  and  its  customer  that  demand  for  payment  of 


178  BANKING  AND  CREDIT  [XIII 

the  note  will  not  be  made  until  some  time  which  is  convenient  to 
the  borrower.  In  the  case  of  demand  loans  of  this  kind  banks  are 
generally  particularly  anxious  not  to  embarrass  their  customers. 
They  are  just  as  eager  to  continue  a  loan  as  is  the  borrower  and 
seldom  call  for  payment,  provided  the  security  is  satisfactory 
and  the  periodic  interest  payments  are  being  met.  A  large  com- 
mercial bank  in  Boston  states  that  during  its  fifty  years  of  exis- 
tence it  has  not  served  a  single  notice  on  a  borrower  for  payment  of 
a  demand  loan  and  this  case  is  probably  by  no  means  exceptional. 
However,  if  the  demand  for  money  becomes  urgent  or  the  bank  is 
doubtful  of  the  borrower's  solvency,  it  will  not  hesitate  to  protect 
itself  from  loss  by  demanding  payment  instantly. 

4.  Interest  on  Call  Loans. — The  interest  rates  on  demand  or 
call  loans  are  not  customarily  fixed  by  stipulated  agreement  as  in 
the  case  of  time  loans,  but  fluctuate  from  day  to  day  with  the 
money  market.  When  there  is  a  mutual  understanding  between 
the  borrower  and  lender  that  the  loan  will  not  be  called  until  it  is 
convenient  for  the  borrower,  the  rates  usually  do  not  vary  much 
from  those  on  time  loans.  When  no  such  understanding  exists, 
however,  as  in  the  case  of  brokers  and  traders  in  the  produce  and 
stock  exchanges,  a  bank  will  generally  make  a  call  loan  at  a  lower 
rate  of  interest  than  is  charged  for  a  time  loan.  A  bank  is  willing 
to  do  this  because  in  order  to  keep  its  assets  liquid  it  is  essential 
that  a  considerable  amount  of  the  loans  be  recallable  at  short 
notice.  On  occasions  of  financial  stringency  or  crisis,  however, 
the  fluctuations  of  the  rates  of  call  loans  are  much  sharper  than 
those  of  time  loans  and  sometimes  reach  an  excessively  high 
figure.  For  example,  in  the  month  of  January,  19 14,  the  call 
rate  varied  between  i  1/2  and  10  percent,  while  the  time  rate 
never  rose  above  5  per  cent.^  In  the  following  March,  when 
there  was  no  disturbance  in  the  money  market,  the  call  money 


'  Financial  Review,  1915,  issued  by  The  Commercial  and  Financial  Chronicle,  p.  62. 


XIII I  COMMERCIAL  LOANS  1 79 

rate  in  New  York  City  ranged  between  i  3/4  and  2  per  cent. 
An  example  of  an  excessively  high  rate  is  that  during  the  October 
panic  of  1907,  when  the  call  rate  rose  to  125  per  cent.^  Such 
rates  are  exceptional  and  are  generally  brought  about  by  the  in- 
sistent demand  of  speculators  who  need  money  to  protect 
marginal  dealings  when  there  is  a  rapid  fall  in  the  price  of  stocks. 
In  many  states  usury  laws  establish  maximum  interest  rates  on 
loans,  but  under  the  laws  of  New  York  a  banker  can  charge  for 
call  loans  above  $5,000  any  rate  the  borrower  is  willing  to  pay. 

From  time  to  time  rates  may  be  changed.  If  the  bank 
wishes  to  increase  the  rate  it  notifies  the  borrower;  if  the  borrower 
wishes  to  lower  the  rate  he  notifies  the  bank.  Such  action  is  re- 
ferred to  as  "marking  up  rates"  or  "marking  down  rates." 
If  the  borrower  considers  the  rate  excessive  he  may  choose  to 
"shift"  the  loan,  that  is,  borrow  elsewhere  and  make  payment 
on  the  original  note. 

5.  Time  Loans. — Time  loans,  as  their  name  implies,  are 
loans  that  have  a  definite  maturity  date.  They  constitute  the 
bulk  of  the  loans  of  almost  any  commercial  bank.  There  are  two 
classes  into  which  time  loans  may  be  subdivided:  (i)  direct 
loans  on  promissory  notes,  and  (2)  discounted  paper.  Time  loans 
running  for  90  days  are  very  common.  Four  months'  paper  is 
also  dealt  in  extensively;  5  and  6  months'  paper  is  less  common; 
and  the  paper  having  a  longer  period  of  maturity  than  4  months 
is  exceptional  in  a  commercial  bank  and  is  confined  principally 
to  agricultural  paper.  A  federal  reserve  bank  may  discount  for 
any  of  its  member  banks  notes,  drafts,  or  bills  of  exchange,  pro- 
vided they  have  a  maturity  at  the  time  of  discount  of  not  more 
than  90  days;  but  if  drawn  or  issued  for  agricultural  purposes  or 
based  on  livestock,  they  may  have  a  maturity  of  not  more 
than  6  months.     To  be  eligible  for  rediscount  at  ^^gleral  reserve 


at  a^ile 


Financial  Review,  1908,  p.  40. 


/• 


I80  BANKING  AND  CREDIT  [XIII 

bank,  6  months'  agricultural  paper,  whether  a  note,  draft,  bill 
of  exchange,  or  trade  acceptance,  must  comply  with  the  regula- 
tions which  would  apply  to  it  if  its  maturity  were  90  days  or  less. 
A  federal  reserve  bank  may  discount  for  any  of  its  member  banks 
bankers'  acceptances  which  have  a  maturity  at  the  time  of  dis- 
count of  not  more  than  3  months'  sight.  A  trade  acceptance  to 
be  eligible  for  purchase  by  federal  reserve  banks  must  have  a 
maturity  at  time  of  purchase  of  not  more  than  90  days. 

Under  the  provisions  of  the  Federal  Reserve  Act  any  member 
bank  may  accept  drafts  or  bills  of  exchange  drawn  upon  it  having 
not  more  than  6  months'  sight  to  run;  furthermore,  any  member 
bank  may  accept  drafts  or  bills  of  exchange  drawn  upon  it  having 
not  more  than  3  months'  sight  to  run,  if  such  paper  is  drawn  by 
banks  in  foreign  countries  or  dependencies  or  insular  possessions 
of  the  United  States  for  the  purpose  of  furnishing  dollar  exchange 
as  required  by  the  usage  of  trade  in  the  respective  countries, 
dependencies,  or  insular  possessions.  The  regulations  regarding 
agricultural  loans  of  member  banks  provide  that  no  loan  secured 
by  farm  land  shall  have  a  maturity  of  more  than  five  years  from 
the  date  on  which  it  was  purchased  or  made  by  the  bank,  and 
that  no  loan  secured  by  other  real  estate  shall  have  a  maturity  of 
more  than  one  year  from  such  date. 

6.  Interest  on  Time  Loans. — The  rates  of  interest  on  time 
loans  of  different  periods  of  maturity  vary  according  to  the  money 
market  not  only  at  the  time  when  the  loan  is  negotiated  but  as  to 
what  may  be  expected  in  the  near  future.  If  there  is  a  large 
supply  of  loanable  funds  with  the  expectation  that  special  de- 
mands will  arise  in  the  course  of  3  months,  a  4  months'  time  loan 
will  bear  considerably  higher  rate  of  interest  than  one  for  60  days. 
On  the  other  hand,  if  there  is  a  present  stringency  which  there  is 
reason  to  think  will  be  relieved  in  a  few  weeks,  the  longer  loan 
will  enjoy  the  lower  rate.  For  example,  in  December,  19 13, 
60-day  loans  were  placed  at  4  3/4  to  5  1/2  per  cent  and  4-month 


XIII 1  COMMERCIAL  LOANS  l8l 

loans  at  from  41/2  to  5  per  cent.  In  the  following  month  of 
February,  60-day  loans  fell  to  2  1/2  to  2  3/4  and  4-month  loans 
to  2  3/4  to  3  1/4  per  cent.  In  the  first  instance  the  shorter  loans 
bore  the  higher  rate;  in  the  second,  the  longer  loans. ^ 

The  ratios  of  demand  and  time  loans  vary  in  different  parts  of 
the  country.  For  example,  in  New  York  City  call  loans  in  191 9"* 
constituted  more  than  one-fourth  of  all  loans  and  in  Boston  about 
one-fifth.  In  Nashville,  Tennessee,  the  proportion  was  but  one- 
twelfth.  In  some  years  the  call  loans  in  New  York  City  have 
run  as  high  as  one-half  of  the  total  loans  of  all  kinds. 

7.  Interest  and  Discount  Calculations. — Interest  which  is 
collected  or  deducted  by  the  lender  at  the  time  the  loan  is  made 
is  called  "discount."  Discount  is  thus  distinguished  from  real 
interest,  which  is  payable  at  maturity,  or,  in  the  case  of  demand 
loans  or  long-time  loans,  at  stated  intervals  (monthly,  quarterly, 
or  semiannually) ,  or  at  the  payment  of  the  loan.  "To  discount " 
means  either  to  buy  or  to  sell  bills  and  notes  before  their  ma- 
turity. With  almost  no  exceptions  banks  in  buying  bills  of 
exchange  discount  them,  whereas  in  the  case  of  a  straight  loan 
interest  rates  are  more  commonly  employed. 

In  order  to  show  the  distinction  between  discount  and  in- 
terest, let  us  consider  the  following  two  problems: 

I.  An  Interest  Problem.  A  merchant  has  borrowed  from  his  bank 
on  a  2  months'  note  for  $10,000  and  bearing  interest  at  7  per  cent.  What 
sum  will  be  required  to  discharge  the  debt  at  the  maturity  of  the  note? 

Interest  for  one  year  on  $10,000  at  7  per  cent  is  $700. 

Interest  for  2  months,  or  1/6  of  a  year  =  1/6  of  $700,  or  $1 16.67. 

Amount  required  to  discharge  the  debt: 

Principal $lo,ooo.oo 

Plus  interest 116.67 

Amount  due  at  maturity $10,1 16.67 

i  Financial  Review,  I9'i5.  PP-  62-63. 
■  •*  Report  of  Comptroller  of  Currency,  1919.  Vol.  II,  p.  158. 


l82  BANKING  AND  CREDIT  ■  [  XIII 

2.  A  Discount  Problem.  A  merchant  has  sold  to  his  bank  a  sight 
bill  for  $10,000,  60  days  before  maturity  and  on  the  basis  of  a  discount 
rate  of  7  per  cent.  Determine  discount  charged  by  the  bank  and  the 
proceeds  obtained  by  the  merchant. 

Discount  for  one  year  on  $10,000  at  7  per  cent  is  $700. 

Discount  for  60  days  (1/6  of  a  year)  =  1/6  of  $700,  or  $116.67. 

Discount  and  proceeds: 

Face  of  bill $10,000.00 

Deduct  discount  for  60  days 116.67 

Proceeds $9,883.33 

In  the  problems  above  the  interest  in  the  first  illustration  is 
exactly  the  same  as  the  discount  in  the  second.  The  borrower, 
however,  pays  more  for  the  use  of  his  funds  in  the  second  illus- 
tration, for  the  reason  that  he  obtains  a  loan  of  $9,883.33  as  com- 
pared with  S  10,000  when  he  borrows  on  a  note. 

Although  the  use  of  a  discount  rate  as  compared  with  an  in- 
terest rate  gives  the  lender  an  advantage,  the  practice  of  dis- 
counting is  probably  largely  due  to  the  fact  that  it  is  a  more  con- 
venient method  of  calculation,  particularly  in  connection  with 
bills  of  exchange.  Unless  the  rate  is  high  and  the  time  involved 
long,  it  makes  no  great  difference  whether  interest  or  discount  is 
figured. 

8.  Basis  of  Calculation. — The  banking  custom,  sanctioned 
by  law,  is  to  make  interest  and  discount  calculations  on  the  as- 
sumption that  there  are  30  days  to  the  month  and  360  days  to 
the  year,  although  in  many  small  country  banks  the  365-day 
basis  is  used.  The  360-day  method  is  of  advantage  to  the 
lender.  On  a  loaning  account  of  $50,000,000  at  an  average  rate 
of  4  per  cent,  a  bank  would  earn  as  additional  interest  $27,777.78 
for  the  extra  5  days  in  an  ordinary  year,  and  $33,333.33  for  a  leap 
year. 

As  an  example  of  how  time  is  computed  on  a  loan,  a  6  months' 
note  dated  March  15  and  maturing  September  15  would  bear 


XIII  ]  COMMERCIAL  LOANS  1 83 

interest  for  184  days,  and  on  a  360-day  basis  would  bear  184/360 
of  a  year's  interest.  If  the  note  were  dated  September  15  and 
matured  March  15,  the  number  of  days  would  be  181.  Discount 
is  customarily  charged  for  every  day  from  date  of  credit  to  date  of 
maturity,  excluding  the  former  and  including  the  latter.  In  some 
states  the  laws  allow  banks  to  charge  interest  for  the  day  of  dis- 
count as  well  as  the  day  of  maturity.  The  three-days-of-grace 
rule  still  applies  in  some  states  to  time  loans,  although  interest 
is  charged  for  the  days  of  grace.  No  grace  is  allowed  in  the 
payment  of  a  demand  note. 

It  is  the  universal  practice  to  compute  bond  interest  on  the 
basis  of  360  days  to  the  year,  and  this  also  applies  to  United 
States  government  bonds,  except  in  dealing  with  the  United 
States  government  or  the  federal  reserve  bank.  This  interest  is 
figured  on  the  month  and  day  basis,  taking  30  days  to  the  month. 
For  example,  if  coupon  interest  began  to  run  from  October  i, 
and  the  bond  was  sold  on  November  3,  the  accrued  interest  would 
be  figured  for  32  days  on  the  basis  of  360  days  to  the  year.  The 
United  States  Treasury,  however,  pays  accurate  interest  on  the 
basis  of  365  days  to  the  year  on  government  bonds  and  notes 
outstanding.  Also  the  reserve  banks  compute  interest  and  dis- 
count on  a  365-day  basis  in  dealing  with  member  banks. 

9.  Discounting  Interest-Bearing  Notes. — If  an  interest- 
bearing  note  is  offered  for  discount  it  is  customary,  in  computing 
the  interest  which  will  be  due  at  maturity,  to  figure  the  actual 
number  of  days,  provided  the  note  is  drawn  payable  in  30,  60, 
90  days,  etc.,  or  with  a  fixed  maturity.  If,  however,  the  note 
should  be  drawn  payable  in  3,  4,  or  6  months,  interest  would  be 
computed  on  the  basis  of  months  and  days.  In  every  case, 
however,  when  the  loan  matures  on  a  Saturday,  Sunday,  or  holi- 
day, interest  to  the  next  business  day  is  added.  In  discount- 
ing notes  bearing  interest  it  is  customary  to  discount  the  interest 
as  well  as  the  principal.     Thus  a  $1,000  note  for  one  year  and 


l84  BANKING  AND  CREDIT  [XIII 

bearing  interest  at  6  per  cent  amounts  to  $i,o6o,  but  if  dis- 
counted at  the  beginning  of  the  year  would  yield  as  proceeds 
$996.40,  and  not  $1,000. 

10.  One  Bank's  Methods  of  Computing  Interest  and  Dis- 
count.— One  prominent  New  York  bank  in  explaining  its  methods 
of  computing  interest  and  discount  writes  as  follows: 

It  is  the  custom  in  this  city,  and  we  believe  the  general  prac- 
tice throughout  the  country,  in  discounting  notes  for  any  period 
up  to  six  months  to  compute  the  discount  for  the  actual  number 
of  days  on  the  basis  of  360  days  to  the  year.  In  computing  in- 
terest on  time  loans  where  the  interest  is  made  payable  at  matur- 
ity or  periodically  before  maturity,  we  always  endeavor  to  collect 
interest  on  the  basis  of  actual  number  of  days.  Sometimes, 
however,  an  exception  is  made,  particularly  when  the  loan  is  made 
for  a  certain  number  of  months.  Occasionally,  the  borrower  de- 
clines to  pay  the  actual  number  of  days,  taking  the  stand  that 
six  months  is  one-half  a  year,  three  months  one-quarter  of  a  year, 
etc.  When  this  position  is  taken  by  the  borrower,  we  do  not 
insist  upon  payment  of  the  interest  for  the  actual  number  of  days. 
We  have  noticed  that  in  the  case  of  most  of  our  loans  to  indivi- 
duals Oi  corporations  this  question  is  never  raised.  It  occurs 
principally  in  connection  with  loans  made  to  brokers  on  stock 
exchange  collateral.  We  always  collect  interest  on  demand  loans 
for  the  actual  number  of  days.  In  short,  our  position  is  that  we 
endeavor  to  collect  interest  for  the  actual  number  of  days  on  all 
loans  but  do  not  insist  upon  it  when  the  loan  happens  to  be  made 
for  a  certain  number  of  months,  interest  to  follow. 

11.  Short  Methods  of  Computing  Interest. — There  area 
number  of  short  methods  of  computing  interest  that  can  be  used 
when  tables  are  not  available.  The  following  is  sometimes  used 
by  discount  clerks  for  certain  calculations,  figured  on  the  usual 
basis  of  360  days  to  the  year.  To  find  the  interest  on  a  given 
sum  at  a  given  rate  for  a  given  period,  first  determine  the  interest 
at  6  per  cent,  multiplying  the  principal  by  half  the  number  of 
months  and  one-sixth  the  number  of  days  in  the  period,  and  then 


XIII 


COMMERCIAL  LOANS 


185 


compute  the  interest  for  other  rates  by  making  the  necessary 
additions  or  subtractions.  Thus  the  additions  or  subtractions 
for  interest  rates  other  than  6  per  cent  would  be  calculated  as 
follows : 


Rate 
of  Interest 
2 
3 
4 

4  1/2 
5 


Subtract 
2/3  of  6  per  cent 

1/2    "    "   "      " 

1/3    "    "    "      " 
1/4   "    "   "      " 

1/6   "    "    "      " 


Rate 
of  Interest 


1/2, 


Add 
1/6  of  6  per  cent 

1/4  "  "  "   " 

1/3  ' ' 

1/2  "  "  "   " 
2/3  "  "  "   " 


For  example,  suppose  we  wish  to  find  the  interest  on  $20,000 
for  6  months  and  12  days  at  7  per  cent.  One-half  of  the  months 
is  three,  which  is  equivalent  to  3  per  cent,  and  one-sixth  of  the 
days  is  2,  or  2/10  of  i  per  cent.  Therefore,  the  multiple  is  .032 
and  the  interest  on  $20,000  at  6  per  cent  for  the  time  named  is 
$640.  Consequently,  if  the  rate  is  7  per  cent  the  interest  would 
be  found  by  adding  1/6  of  $640,  which  amounts  to  $746.67  ($640 
plus  $106.67). 

Obviously  6  per  cent  interest  on  $1  for  2  months  (one-sixth 
of  a  year)  is  i  cent,  and  for  6  days,  i  mill.  Hence,  to  find  the 
interest  on  a  given  sum  for  2  months  at  6  per  cent,  move  the 
decimal  point  two  places  to  the  right,  and  for  6  days  three  places 
to  the  right. 


12.  Single-Name  Paper. — Single-name  paper  includes  the 
notes  of  individuals,  firms,  or  corporations  bearing  the  names  of 
the  makers  only.  Although  several  names  may  appear  on  a  note 
either  as  makers  or  indorsers  it  is  still  single-name  paper  if  such 
names  represent  identical  interest,  as  in  the  case  of  a  firm's  sub- 
sidiary organization  doing  business  under  a  separate  name. 

The  use  of  single-name  paper  in  the  United  States  dates  back 
to  the  Civil  War.  The  depreciation  of  the  greenback  and  the 
uncertainty  of  the  value  of  "trade  paper"'  (merchandise  notes) 


l86  BANKING  AND  CREDIT  [XIII 

caused  wholesalers  and  jobbers  to  offer  merchants  large  induce- 
ment for  cash  payments  in  settlement  for  the  purchase  of  goods. 
In  order  to  obtain  funds  to  take  advantage  of  such  discounts, 
merchants  sold  their  single-name  notes  through  brokers  to  banks. 
At  first  the  brokers  handled  the  notes  strictly  on  a  commission 
basis,  but  later  they  purchased  them  outright  to  a  large  extent. 

Until  the  Federal  Reserve  Board  adopted  the  policy  of  es- 
tablishing a  wider  use  of  acceptances,  custom  had  made  single- 
name  paper  by  far  the  most  common  form  of  loan  in  the  United 
States.  Many  of  the  strongest  wholesale  houses  still  follow  the 
policy  of  selling  to  their  customers  on  open  account  without  ask- 
ing for  notes  or  acceptances.  When  these  houses  need  funds  to 
meet  their  obligations  they  have  their  own  notes  discounted  at 
the  bank  or  sell  them  to  a  broker.  Some  merchants  and  manu- 
facturers who  receive  notes  from  customers  hold  this  paper  in 
their  portfolios  and  sell  their  own  notes  when  necessary. 

One  of  the  advantages  of  borrowing  in  the  open  market  on 
single-name  paper  as  compared  with  the  use  of  acceptances  lies 
in  the  simplicity  of  the  transaction.  For  example,  suppose  a 
merchant  wishes  to  borrow  $150,000  for  the  purpose  of  taking 
advantage  of  purchase  discounts  on  some  outstanding  obligations. 
He  draws  up  thirty  of  his  single-name  notes  of  $5,000  each  (or 
some  other  convenient  denomination)  and  disposes  of  them 
through  a  note-broker  who  purchases  the  paper  on,  say,  a  7  per 
cent  basis.  The  broker  will  then  very  likely  sell  the  notes  to 
banks  with  which  he  deals  and  will  charge  each  bank  a  small 
commission  for  the  work  he  has  performed  in  investigating  the 
character  of  the  paper,  in  employing  capital  of  his  own  for  trans- 
acting the  business,  and  in  acting  as  intermediary  between  the 
bank  and  the  borrower.  The  commission  is  usually  1/4  per  cent 
flat;  hence  on  three  months'  paper  it  amounts  to  i  per  cent  per 
annum.  On  this  account  borrowers  put  out  paper  for  as  long  a 
term  as  will  find  a  market — 5  or  6  months.  Under  the  acceptance 
form  of  settlement  the  merchant  would  create  as  many  credit 


XIII]  COMMERCIAL  LOANS  1 87 

instruments  as  he  had  payments  to  make;  this  would  impose 
additional  bookkeeping  upon  the  bank  and  would  increase  the 
collection  cost. 

13.  Accommodation  Paper. — There  are  three  kinds  of  double- 
name  paper:  (i)  accommodation  paper,  (2)  discounted  bills 
(notes)  receivable,  and  (3)  acceptances.  For  convenience, 
acceptances  will  be  discussed  in  another  chapter.  Accommoda- 
tion paper  represents  what  would  otherwise  be  single-name 
paper  if  it  were  not  indorsed  by  one  or  more  parties  who  have 
not  indentical  business  interests  with  the  maker  and  who  thus 
give  the  instrument  an  adcHtional  element  of  security.  From 
the  point  of  view  of  the  holder  the  advantage  of  double-name 
against  single-name  paper,  in  general,  consists  of  the  liability  of 
the  additional  party  to  the  instrument  as  an  indorser.  Although 
in  some  instances  two  names  may  not  offer  any  greater  security 
than  one,  nevertheless,  it  is  generally  recognized  that  ordinarily 
two  names  are  better  than  one.  However,  some  banks  object 
to  accommodation  paper  on  the  ground  that  very  often  the 
borrower  has  secured  the  reluctant  signature  of  some  friend  and 
that  this  arrangement  is  likely  to  cause  trouble  in  collection  if 
the  maker  is  unable  to  meet  his  obligation  at  maturity. 

References 

Fiske,  A.  K.     The  Modern  Bank.     pp.  131-141. 
Holdsworth,  J.  T.     Money  and  Banking,     pp.  259-264. 
Moulton,  H.  G.    Financial  Organization  of  Society,     pp.  374-384. 
Westerfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  I\ ,  pp.  830- 

836;  Vol.  Ill,  pp.  860-862  (computation  of  interest). 
Note:  See  Appendix  A,  Problems  8-1 1. 


,...>-<:^ 


CHAPTER  XIV 

SECURITY   FOR   LOANS 

1.  Collateral  Loans  in  General. — In  taking  a  collateral  loan 
the  borrower  deposits  and  pledges  for  the  security  of  the  lender 
such  items  as  stocks,  bonds,  bills  of  lading,  bills  receivable,  ware- 
house receipts;  or  other  evidences  of  property.  The  security  is 
a  guaranty  that  the  loan  will  be  paid  at  maturity;  if  not  paid,  the 
collateral  may  be  sold  to  reimburse  the  lender.  If  it  is  sold  the 
balance  is  refunded  to  the  borrower  after  the  necessary  amount 
of  the  proceeds  has  been  used  for  reimbursing  the  lender.  Col- 
lateral loans  may  be  "call,"  "short-term,"  or  "long-term." 
Form  15  is  used  by  a  bank  for  collateral  call  loans. 

2.  Banking  Policy  in  Loaning  on  Collateral. — Some  banks, 
even  in  large  cities,  make  few  loans  on  collateral,  while  others, 
and  particularly  trust  companies,  loan  largely  on  such  security. 
When  banks  loan  to  brokers  and  dealers  in  the  stock  and  produce 
exchanges  they  usually  demand  that  the  collateral  be  "mixed," 
that  is,  there  must  not  be  too  much  of  any  one  class  of  security. 
The  market  value  of  the  collateral  must  exceed  the  amount  of 
the  loan  by  a  certain  percentage,  depending  upon  the  character 
of  the  security.  Such  margins  range  commonly  from  10  to  40 
per  cent. 

The  amount  of  margin  allowed  on  acceptable  collateral  is  a 
factor  taken  into  consideration  by  a  bank  in  fixing  the  interest 
rate  on  the  loan.  For  example,  if  the  borrower  hypothecates 
government  bonds  the  margin  required  above  the  amount  of  the 
loan  should  be  small  and  a  comparatively  low  rate  of  interest 
or  discount  might  be  expected. 

No  matter  how  sound  any  security  may  seem  to  be,  the  banker 


i 


XIV  I  SECURITY  FOR  LOANS  189 


Dollars  Boston,  Mass., 19 

On  Demand,  for  value  received promise  to  pay  to  The 

Nation.vl  Hubville  Bank,  of  Boston,  or  order,  at  its  banking  house 

Dollars 

with  interest  at  the  rate  of per  centum  per  annum 

having  deposited  with  said  Bank,  as  Collateral  security  for  payment 
of  this  or  any  other  direct  or  indirect  liability  to  said  Bank,  due  or  to 
become  due,  or  that  may  hereafter  be  contracted 

In  case  of  depreciation  in  the  market  value  of  the  security  hercl>y 

pledged,  or  which  may  hereafter  be  pledged  for  this  loan 

agree  to  furnish,  on  demand,  satisfactory  additional  security, 

so  that  the  market  value  thereof  shall  always  be  at  least per  cent 

more  than  the  amount  of  this  note.  And  failing  to  deposit  such  addi- 
tional security,  this  note  shall  be  deemed  to  be  due  and  payable  forth- 
with, anything  hereinbefore  expressed  to  the  contrary  notwithstanding 
and  the  said  Bank,  or  its  assigns,  may  immediately  reimburse  itself  by 
the  sale  of  the  security,  as  hereinafter  authorized.  And  authority  is 
hereby  given  to  the  said  Bank,  or  to  its  assigns,  to  sell,  assign  and  de- 
liver the  whole  or  any  part  of  the  said  Collateral,  also  any  security  sub- 
stituted therefor  or  added  thereto,  without  notice  or  advertisement, 
either  at  public  or  private  sale,  at  the  option  of  the  said  Bank,  or  its  as- 
signs, on  the  non-performance  of  this  promise;  any  balance  of  the  net 
proceeds  of  such  sale  remaining  after  paying  all  sums,  whether  then  or 

thereafter  payacle,  due  from to  the  said  Bank  on  account  of 

this  note  or  otherwise,  to  be  returned  to 

And  it  is  further  agreed  that  the  said  Bank,  or  its  assigns,  may  l:id  and 
become  purchasers  of  such  sale,  and  no  other  purchaser  shall  be  re- 
sponsible for  the  application  of  the  purchase  money. 

[Signature]     


Form  15.     Collateral  Loan  Agreement 

usually  wishes  to  know  whether  it  can  be  liquidated  quickly. 
The  real  value  of  the  property  back  of  a  stock  or  bond  is  highly 
important  for  the  investor,  but  for  the  banker  who  is  examining 
the  merits  of  a  security  as  collateral,  marketability  is  much  more 
important  than  steadiness  of  value  or  ultimate  safety.     If  the 


1 90  BANKING  AND  CREDIT  [XIV 

securities  pledged  are  listed  upon  the  stock  exchange  and  can 
be  readily  sold,  the  bank  in  ordinary  times  is  amply  protected,  as 
it  can  promptly  realize  on  its  security  by  selling  the  stocks  and 
bonds.  However,  the  fact  that  a  security  is  a  listed  one  and  is 
dealt  in  even  on  the  New  York  Exchange,  does  not  in  itself 
warrant  its  being  accepted  as  satisfactory  collateral,  any  more 
than  the  fact  that  a  security  is  not  listed  should  prevent  it  from 
being  considered  acceptable  collateral.  Very  often  a  listed 
security  may  at  a  particular  time  be  subject  to  wide  fluctuations 
in  price,  or  its  market  may  become  so  narrow  as  not  to  be  able 
to  absorb  any  appreciable  quantity  of  it  without  a  substantial 
fall  in  price. 

3.  Obtaining  Legal  Title  to  Pledged  Property. — In  receiving 
collateral  on  a  loan  it  is  necessary  for  a  bank  to  place  itself  in  a 
position  to  obtain  legal  title  to  the  property  in  case  of  default  of 
the  borrower.  To  accomplish  this  in  the  case  of  Wall  Street 
call  loans,  banks  require  that  the  securities  be  a  good  delivery 
under  the  rules  of  the  New  York  Stock  Exchange.  When  the 
borrower  deposits  securities  drawn  in  his  name,  they  must  be 
indorsed  in  blank.  If,  however,  the  borrower  wishes  to  pledge 
securities  drawn  to  the  order  of  some  other  person,  it  is  necessary 
to  obtain  a  certificate  or  agreement  signed  by  this  person  giving 
the  borrower  the  right  to  hypothecate  the  property. 

Although  the  rules  governing  the  pledging  of  collateral 
include  many  technical  points  in  which  the  business  man  is 
not  particularly  interested,  it  is  well  to  understand  the  general 
nature  of  an  hypothecation  certificate.  "To  hypothecate,'' 
according  to  the  commercial  use  of  the  term,  means  to  make  the 
legal  acknowledgments  which  constitute  the  holder  of  a  promis- 
sory note  or  bill  of  exchange  also  a  holder  of  the  stocks  or  bonds, 
bills  of  lading,  warehouse  receipts,  insurance  certificates,  or  other 
evidences  of  property  pledged  to  secure  the  debt  or  liability;  the 
hypothecation  certificate  is  the  instrument  which  contains  a 


XIV]  SECURITY  FOR  LOANS  IQI 

formal  legal  recital  of  such  acknowledgments.  Hypothecation 
certificates  are  used  to  a  large  extent  in  financing  foreign  trade 
for  the  purpose  of  pledging  the  bill  of  lading  (and  the  mer- 
chandise covered  by  it),  the  insurance  certificate,  and  other  ship- 
ping documents  as  collateral  security  for  the  draft. 

Borrowers  often  wish  to  substitute  or  withdraw  their  col- 
lateral temporarily.  Banks  provide  for  this  by  requiring  their 
customers  to  fill  out  application  blanks  in  case  of  substitutions, 
or  to  sign  receipts  in  the  case  of  temporary  withdrawals.  Some 
of  the  more  important  of  the  special  types  of  collateral  loans  will 
now  be  briefly  considered  under  separate  headings.  The  use  of 
warehouse  receipts,  bills  of  lading,  trust  receipts,  etc.,  as  col- 
lateral has  already  been  discussed  in  the  chapter  on  commercial 
credit  documents. 

4.  Bills  Receivable. — By  discounted  bills  (notes)  receivable 
(receivables)  is  meant  customers'  promissory  notes  which  have 
been  received  by  merchants  and  taken  by  them  to  the  bank  to  be 
discounted.  Suppose  that  a  retail  merchant  has  bought  a  lot  of 
merchandise  which  he  intends  to  dispose  of  in  90  days.  Not 
having  sufficient  funds  for  cash  payment,  he  makes  arrangements 
whereby  the  wholesaler  agrees  to  take  his  90-day  note.  The 
wholesaler,  in  turn,  having  indorsed  the  note,  turns  it  over  to 
his  bank  and  receives  credit  for  the  proceeds.  Although  bills 
(notes)  receivable  enable  a  seller  to  realize  funds  readily,  there  is 
this  to  be  said  against  them :  The  indorsement  of  a  "  receivable ' ' 
and  its  sale  creates  a  contingent  liability  which  in  some  cases 
may  prove  to  be  an  important  consideration.  Sometimes  a 
borrower,  instead  of  discounting  notes  (bills  receivable)  that  he 
receives  in  the  course  of  business,  chooses  to  negotiate  at  his 
bank  a  direct  loan  on  the  basis  of  his  personal  note  secured  by 
the  bills  receivable  pledged  as  collateral.  If  any  of  the  bills 
thus  pledged  mature  during  the  term  of  the  loan  they  must  be 
"taken  up"  and  replaced  with  other  security,  or  a  part  of  the 


192  BANKING  AND  CREDIT  f  XIV 

loan  must  be  paid.  The  note  of  a  merchant  or  manufacturer 
secured  by  his  bills  receivable  is  considered,  by  the  federal  reserve 
banks,  to  be  desirable  paper.  However,  if  issued  with  the  object 
of  carrying  collateral  for  a  speculative  purpose,  or  collateral  in 
the  nature  of  stocks  and  bonds  other  than  securities  of  the  United 
States,  the  note  would  not  be  eligible  for  rediscount  at  the  federal 
reserve  bank. 

5.  Assignment  of  Accounts  Receivable. — Accounts  receiv- 
able are  sometimes  used  as  collateral  for  loans  when  business  firms 
cannot  obtain  from  their  customers  acceptances  or  notes  for  goods 
sold.  Discount  companies,  commercial  finance  companies,  and 
others  engaging  in  loans  of  this  character,  usually  select  some  of 
the  larger  and  better  accounts,  and  then  require  the  borrower 
to  assign  such  accounts  to  them.  The  assignment  may  be  made 
openly  or  secretly.  In  the  event  of  the  former  plan  notice  is 
served  on  the  debtors  that  the  accounts  have  been  pledged  and 
that  payment  must  be  made  to  the  bank  or  assignee  instead  of 
the  merchant.  Any  surplus  thus  received  above  the  amount  of 
the  loan  is  returned  to  the  borrower.  When  secret  assignments 
of  accounts  are  made,  the  borrower  is  required  to  sign  a  state- 
ment promising  to  apply  directly  all  receipts  from  such  accounts 
to  the  reduction  of  the  loan.  Checks  and  drafts  from  the 
debtors  must  be  indorsed  in  favor  of  the  assignee  and  sent  to  him 
directly,  and  must  not  be  deposited  in  a  bank  for  the  account  of 
the  borrower. 

Many  so-called  "commercial  bankers"  make  a  business  of 
loaning  on,  or  more  precisely,  buying,  accounts  receivable.  Com- 
mission merchants,  also  known  as  "factors,"  not  only  sell  goods 
for  customers  and  mills  for  whom  they  act  as  selling  agents,  but 
often  buy  accounts.  In  a  typical  case  a  factor  advances  the 
manufacturer  80  per  cent  of  the  amount  of  the  invoice  as  shown 
by  the  account  and  charges  him  interest  for  the  time  it  has  to 
run.     If  the  manufacturer  desires  the  20  per  cent  also  or,  in  other 


XIV]  SECURITY  FOR  LOANS  193 

words,  a  guaranty  of  payment  of  the  full  amount  of  the  bill,  the 
factor  will  charge  an  extra  percentage  for  the  service  and  risk 
involved.  When  manufacturers  and  merchants  make  a  practice 
of  openly  assigning  accounts  receivable,  it  is  customary  for  their 
billheads  to  contain  some  such  statement  as:  *'This  bill  has  been 
assigned  to  the  ABC  Company  and  all  payments  must  be  made 
to  them  direct." 

Accounts  receivable  are  not  generally  considered  to  be  a  high 
class  of  collateral  security.  A  careful  investigation  of  every  as- 
signed account  must  be  made;  and,  besides,  the  handling  of  the 
loan  and  collection  of  the  payments  involve  considerable  work. 
Moreover,  borrowers  who  resort  to  loans  on  this  kind  of  security 
have,  very  often,  exhausted  every  other  means  of  borrowing  and 
consequently  need  to  be  carefully  watched.  Finally,  it  is  necessary 
to  allow  considerable  margin  for  shrinkage  inevitable  in  all  such 
loans.  Under  the  rulings  of  the  Federal  Reserve  Board  the 
assignment  of  an  open  account  is  not  negotiable  paper  and  is  not 
eligible  for  rediscount  by  a  federal  reserve  bank. 

6.  Merchandise  Loans. — Merchandise  loans  are  those  made 
upon  the  security  of  warehouse  receipts,  bills  of  lading,  trust 
receipts,  and  other  documents  covering  commodities.  These 
loans  are  commonly  negotiated  for  the  purpose  of  financing  the 
manufacture,  transportation,  and  marketing  of  the  great  staples 
such  as  wheat,  cotton,  tobacco,  sugar,  and  many  other  commodi- 
ties. The  machinery  for  handling  these  loans  has  been  per- 
fected to  such  a  degree  that  often,  by  changing  the  collateral 
successively  from  bills  of  lading  to  trust  receipts,  to  warehouse 
receipts,  the  same  loan  covers  the  progress  of  raw  material  from 
the  primary  market  through  the  manufacturing  processes  and 
into  the  retail  market,  when  the  loan  is  paid  ofT  from  the  pro- 
ceeds of  sales,  purther  discussion  of  bills  of  lading,  warehouse 
receipts,  trust  receipts,  etc.,  may  be  found  later  in  this  chapter 
and  also  in  the  chapter  on  commercial  credit  documents. 


194  BANKING  AND  CREDIT  [XIV 

7.  Cattle  Loans. — Although  local  banks  loan  sums  in  the 
aggregate  direct  to  cattle-raisers,  the  bulk  of  the  cattle  paper  in 
the  United  States  is  handled  in  the  first  instance  by  cattle  loan 
companies,  which  exist  in  all  the  large  livestock  markets  and  to 
some  extent  in  the  producing  centers.  These  companies,  while 
holding  a  portion  of  their  loans  until  maturity,  are  essentially 
brokers  between  cattle-growers  and  investors,  and  follow  the 
plan  of  rediscounting  their  paper  in  large  financial  centers. 

There  are  decided  elements  of  strength  in  cattle  paper  that 
make  it  highly  attractive  to  bankers.  Besides  being  self- 
liquidating,  in  that  when  the  cattle  are  sold  the  proceeds  are 
available  for  payment  of  the  loan,  the  paper  is  based  upon  a 
life  necessity  for  which  there  is  at  all  times  a  ready  and  compara- 
tively stable  market.  Also,  unlike  the  regular  commercial  paper 
houses,  cattle  loan  companies  indorse  the  paper  which  they  sell, 
and  forward  with  the  note  a  chattel  mortgage  covering  the  cattle, 
the  feed,  and  sometimes  the  equipment  for  handling  the  stock, 
such  as  horses  and  machinery. 

8.  Classes  of  Cattle  Loans.— For  purposes  of  description 
cattle  paper  may  be  classified  under  three  heads:  (i)  feeder  loans, 
(2)  stocker  loans,  (3)  dairy  loans. 

Feeder  loans,  also  known  as  "live  beef  loans,"  are  usually 
made  to  enable  producers  to  purchase  beef  steers  which  are  ready 
for  the  last  stage  of  fattening.  These  loans  are  made  to  mature 
within  3  to  6  months,  according  to  the  age  of  the  animals  and  the 
period  of  feeding.  If  the  borrower  is  considered  to  be  a  man  of 
abiHty  and  good  moral  risk  and  has  the  proper  facilities  for  car- 
ing for  the  animals,  it  is  not  uncommon  to  advance  him  the  en- 
tire purchase  price  of  the  cattle.  Steers  in  the  fattening  pen 
gain  in  weight  on  the  average  2  pounds  apiece  per  day,  and  there- 
fore as  the  maturity  of  the  loan  approaches  the  security  increases 
both  on  account  of  quantity  and  quality. 

Stocker  loans  are  made  on  cows,  young  heifers,  and  steers 


XIV]  SECURITY  FOR  LOANS  195 

which  are  being  pastured  or  kept  on  farms  and  ranches  for  growth 
and  breeding  purposes.  This  paper  commonly  runs  for  6  months 
with  a  probabiHty  of  renewal  of  from  one  to  four  times.  Because 
of  the  natural  increase  in  calves  and  the  growth  of  young  cattle, 
the  security  behind  stocker  loans  is  constantly  increasing.  Cattle  in 
pastures,  however,  are  subject  to  more  vicissitudes  of  the  weather, 
disease,  and  accident  than  steers  in  the  fattening  pen;  also, 
because  of  the  longer  duration  of  the  paper,  stocker  loans  do  not 
possess  all  the  advantages  of  feeder  loans.  However,  the  ele- 
ment of  risk  is  small,  the  paper  yields  a  slightly  higher  rate,  and 
is  readily  purchased  by  banks  and  investors. 

Dairy  loans  usually  run  for  long  periods  and  arc  customarily 
paid  in  monthly  instalments  out  of  the  proceeds  of  the  butter  and 
milk.  These  loans  are  seldom  made  by  cattle  loan  companies, 
but  instead  are  handled  by  local  banks  which  are  in  a  better 
position  to  judge  the  character  of  the  borrower  and  his  prospects 
of  meeting  the  obligation  at  maturity.  Dairy  paper  is  not  con- 
sidered liquid  and  cannot  be  readily  rediscounted  or  sold  outside 
of  the  district  of  its  origin;  therefore  in  financial  centers  it  is 
considered  inferior  to  either  feeder  or  stocker  loans. 

9.  Cotton  Loans. — The  financing  of  the  cotton  crop  in  a 
typi(*Gl  case  involves  extending  credit  to  the  planter,  the  factor, 
and  the  buyer.  In  the  spring  the  planter  will  need  seed,  mules, 
fodder,  machinery,  labor,  and  household  provisions,  and  will 
borrow  the  requisite  funds  from  his  local  bank  or  from  a  cotton 
factor.  The  factor  is  often  a  merchant  also  and  may  furnish 
the  planter  with  provisions  as  well  as  money.  In  most  instances, 
however,  provisions  for  the  planter's  commissary  are  obtained  on 
credit  from  a  wholesale  grocer. 

The  factor  is  essentially  a  commission  merchant  who  loans 
funds  in  order  to  obtain  consignments  of  cotton.  The  loan  may 
be  secured  by  chattel  mortgage  or  realty  mortgage,  or  the  obliga- 
tion of  the  planter  may  be  simply  on  open  account.    Factors  are 


196  BANKING  AND  CREDIT  I  XIV 

generally  persons  of  financial  strength  and  are  in  a  position  to 
borrow  from  banks  by  pledging  cotton  warehouse  receipts  or 
other  collateral. 

At  picking  and  ginning  time  the  planter  either  sells  to  a  wagon 
buyer  on  the  street  in  his  home  town,  or  he  consigns  his  cotton  to 
a  factor  in  a  larger  city,  drawing  generally  for  additional  funds  at 
the  same  time.  When  the  cotton  is  sold  by  the  factor  for  the 
planter,  the  debts  of  the  latter  are  settled. 

10.  Financing  the  Buyer. — In  order  to  illustrate  how  buyers 
are  sometimes  financed,  suppose  that  Jordan  Brothers  of  Atlanta 
send  a  buyer  into  the  cotton  section  of  Georgia  armed  with  a  letter 
of  introduction  to  a  local  bank.  The  letter  will  state  that  Jordan 
Brothers  will  be  responsible  for  all  drafts  drawn  on  them  when 
accompanied  by  "  Order  notify  "  bills  of  lading.  The  buyer  will 
then  purchase  from  the  factors  or  planters  what  cotton  he  wants, 
making  payment  by  checks  on  the  local  bank.  Later  in  the  day 
he  will  obtain  from  the  railroad  company  bills  of  lading  covering 
so  many  bales  of  cotton  of  a  specified  weight  and  bearing  certain 
designated  marks.  The  bills  of  lading  will  be  attached  to  a 
sight  draft  on  Jordan  Brothers  of  Atlanta  and  will  be  turned  over 
to  the  local  bank  which  places  the  item,  less  the  usual  exchange, 
to  the  buyer's  credit. 

A  few  days  later  the  draft  is  received  by  some  Atlanta  bank 
which  presents  it  to  Jordan  Brothers  who  in  turn  take  it  up  with 
a  check.  With  possession  of  the  bills  of  lading  Jordan  Brothers 
can  now  secure  the  cotton  from  the  railroad  company.  But  if 
the  cotton  has  not  arrived  and  Jordan  Brothers  wish  to  borrow 
funds,  they  may  do  so  by  hypothecating  with  their  bank  the  bills 
of  lading.  When  the  cotton  arrives  it  will  be  necessary  to  obtain 
the  bills  of  lading  and  surrender  them  to  the  railroad  company 
before  the  latter  will  deliver  the  merchandise.  Arrangements 
for  this  are  made  by  Jordan  Brothers'  signing  a  trust  receipt, 
binding  themselves  not  to  dispose  of  the  cotton,  except  for  the 


XIV 1  SECURITY  FOR  LOANS  I97 

benefit  of  the  bank.  The  cotton  may  now  be  placed  in  a  ware- 
house, or  it  may  be  reshipped  to  some  eastern  or  northern  market, 
or  it  may  be  exported  to  Europe. 

II.  Grain  Bills  and  Paper. — In  the  marketing  of  grain  the 
farmer  has  at  least  four  methods  which  he  may  follow : 

1.  Outright  sale  to  a  country  warehouse  or  elevator. 

2.  Sale  after  storage  in  the  country  warehouse  or  elevator. 

3.  Sale  on  contract  before  actual  delivery. 

4.  Sale  on  his  own  account  in  the  terminal  market. 

The  relative  importance  of  these  methods  varies  in  different 
sections  of  the  country,  but  in  the  large  grain-producing  states 
of  the  Central  West  and  Northwest  the  first  method  of  outright 
sale  is  the  most  common.  When  the  crop  is  harvested  the  grain  is 
delivered  to  country  elevators  and  warehouses  in  specially  con- 
structed wagon  boxes  or  tanks.  Upon  his  arrival  at  the  local 
market  the  farmer  will  go  from  one  buyer  to  another  until  he  has 
found  where  he  can  obtain  the  most  money  for  his  load.  Upon 
receipt  of  the  grain  the  local  elevator  or  warehouse  will  roughly 
grade  the  grain,  issuing  its  receipts,  which  are  paid  for  in  cash  at 
the  office.  The  wagon  load  of  grain  is  now  placed  in  a  bin  in 
the  elevator  or  warehouse,  from  which  it  will  be  shipped  to  a 
terminal  market  when  there  is  enough  of  equal  grade  to  make 
a  carload. 

Let  us  now  assume  that  the  grain  is  shipped  from  the  local 
elevator  to  a  lake  port,  say,  Duluth.  Here  it  is  oihcially  graded, 
perhaps  as  No.  i  northern  wheat,  this  grading  being  accepted  in 
all  markets.  A  draft  is  drawn  on  the  Duluth  dealer,  with  bill  of 
lading  attached,  and  is  sent  to  a  bank  in  that  city.  If  the  Duluth 
dealer  is  borrowing  on  the  shipment,  the  bill  of  lading  will  be 
security  to  the  bank  for  the  advance.  Assuming  that  the  grain 
is  to  be  forwarded,  it  must  be  handled  by  an  elevator,  and  there- 
fore the  bill  of  lading  must  be  surrendered  before  this  can  take 


198  BANKING  AND  CREDIT  [XIV 

place.  The  bank  will  require  its  customer  to  sign  a  trust  receipt 
which  protects  the  bank's  control  of  the  grain  while  the  transfer 
is  being  made. 

When  the  grain  is  placed  on  board  a  steamer  bound  for 
Buffalo,  the  Duluth  dealer  will  draw  on  a  Buffalo  house  to  which 
he  made  the  sale,  and  attaching  the  bill  of  lading,  the  inspection 
certificate,  and  insurance  certificate  he  will  turn  them  over  to  his 
local  bank,  which  will  forward  them  for  collection.  Upon  pay- 
ment of  the  draft  in  Buffalo  the  bill  of  lading  is  surrendered  for  a 
trust  receipt,  which  is  shortly  afterwards  replaced  by  a  railroad 
bill  of  lading  covering  the  shipment  to  New  York. 

A  draft  is  now  drawn  on  New  York  and  is  forwarded  with  raU 
bill  and  other  documents  for  payment.  From  the  railroad  the 
grain  is  put  into  a  floating  elevator  at  New  York,  the  bank  hold- 
ing a  trust  receipt  while  the  transfer  is  being  made.  When  the 
grain  is  on  board  the  steamer,  a  draft  is  drawn  on  the  European 
buyer  or  his  bank  and  there  is  attached  an  ocean  bill  of  lading, 
insurance  certificates,  and  other  miscellaneous  shipping  papers. 
The  bill  with  documents  attached  is  then  sold  to  a  New  York 
bank  dealing  in  foreign  exchange. 

Local  buyers  and  dealers  occasionally  borrow  on  their  holdings 
in  grain,  but  ordinarily  they  sell  most  of  the  grain  shortly  after 
obtaining  it  to  dealers  at  the  primary  markets.  These  dealers 
while  awaiting  favorable  sales  store  large  quantities  of  grain  in 
the  central  elevators  at  the  primary  and  seaboard  markets,  and 
pledge  to  banks  as  the  basis  for  loans  the  elevator  or  warehouse 
receipts.  This  so-called  "grain  paper  "  is  carefully  regulated  by 
law  in  the  western  grain  states.  Public  elevators  and  ware- 
houses in  these  parts  of  the  country  are  subject  to  state  control 
and  also  to  the  rules  of  the  produce  exchange,  and  the  receipts 
that  they  issue  are  readily  accepted  as  collateral  by  banks.  Some 
western  grain  paper  is  sold  to  eastern  banks  of  the  United 
States  and  also  to  Canadian  banks  through  commercial  paper 
brokers. 


XIV]  SECURITY  FOR  LOANS  199 

12.  Mortgage  Loans  on  Real  Estate. — Real  estate  and  other 
forms  of  permanently  invested  capital  are  poor  collateral  for  a 
commercial  bank,  because  they  cannot  be  quickly  converted  into 
cash.  National  banks,  until  the  enactment  of  the  Federal 
Reserve  Act,  were  prohibited  from  loaning  on  real  estate  mort- 
gages but  could  temporarily  accept  a  mortgage  to  secure  a  pre- 
viously existing  debt  on  which  the  debtor  had  defaulted.  Some 
state  bank  laws  contain  similar  provisions  with  regard  to  real 
estate  loans. 

Under  the  new  law  any  member  bank  not  situated  in  a  central 
reserve  city  may  legally  make  loans  secured  by  improved  and 
unencumbered  farm  land  or  other  real  estate  as  provided  for  by 
Section  24  of  the  Federal  Reserve  Act.  Certain  conditions  and 
restrictions,  however,  must  be  observed : 

1.  There  must  be  no  prior  lien  on  the  land;  in  other  words, 
the  lending  bank  must  secure  a  first  mortgage  or  deed  of  trust. 

2.  The  amount  of  the  loan  must  not  exceed  50  per  cent  of  the 
actual  value  of  the  land. 

3.  The  maximum  amount  of  such  loans  which  a  member  bank 
may  make  must  not  exceed  one-third  of  its  time  deposits  or  one- 
fourth  of  its  capital  and  surplus. 

13.  General  Principles  for  Buying  Commercial  Paper  Without 
Collateral.^ — Although  a  bank  in  buying  commercial  paper  with- 
out collateral  cannot  determine  the  desirability  of  a  particular 
offering  solely  on  the  basis  of  some  previously  developed  rule-of- 
thumb  but  must  judge  each  case  for  the  most  part  by  itself, 
nevertheless,  there  are  certain  guiding  principles  which  have 
wide  application  in  this  field.  These  may  be  enumerated  as 
follows : 

I.  Desirability  of  Paper  Based  on  Staple  Commodities.  The 
paper  of  concerns  dealing  in  staple  commodities  or  the  neces- 
sities of  life  is  recognized  as  generally  being  more  desirable  than 
the  paper  of  less  essential  industries.      In  order  to  have  prime 


■/  ' 


200  BANKING  AND  CREDIT  [XIV 

commercial  paper  it  is  necessary  that  the  proceeds  be  used  for 
financing  an  article  that  has  a  wide  and  active  market  which 
thereby  makes  it  easy  for  the  loan  to  be  self-liquidated.  Many 
lines  of  goods,  such  as  highly  specialized  groceries,  jewelry,  or  art 
goods,  are  slow-moving  commodities  and  concerns  handling  them 
have  a  low  rate  of  turnover.  Paper  based  upon  such  commodi- 
ties obviously  does  not  liquidate  itself  as  rapidly  as  paper  issued 
for  articles  that  stay  on  a  merchant's  shelves  only  a  short  time. 
Paper  issued  for  the  purpose  of  financing  consumptive  loans,  such 
as  the  purchase  of  a  pleasure  automobile,  is  not  founded  on  sound 
banking  principles,  for  the  reason  that  the  use  of  such  an  article 
will  not  in  itself  produce  revenue  for  liquidating  the  loan,  whereas 
in  the  case  of  a  commercial  car  such  revenue  would  be  derived. 

2.  Diversification  of  Risks.  Banks  usually  find  it  a  good 
policy  to  diversify  their  paper  so  that  risks  are  distributed  both 
as  to  location  of  borrowers  and  the  nature  of  their  business.  This 
policy  is  based  upon  the  theory  that  depressions  are  not  likely 
to  occur  simultaneously  either  in  all  parts  of  the  country  or  in 
all  lines  of  industry. 

3.  Profitable  Operation  of  Enterprise  for  a  Series  of  Years. 
Just  as  a  continuous  dividend  record  for  a  considerable  period 
together  with  a  growth  in  the  surplus  account  are  excellent  signs 
in  the  case  of  a  stock  which  has  been  purchased  for  investment,  so 
in  buying  of  commercial  paper  the  profitable  operation  of  an 
enterprise  for  a  series  of  years  is  a  good  indication  of  the  business 
ability  of  the  borrower.  With  few  exceptions  sound  enterprises 
are  the  results  of  gradual  development  and  healthy  growth,  and 
cannot  be  established  in  a  short  time.  Therefore  past  achieve- 
ment as  well  as  present  standing  points  toward  probable  success 
in  the  future. 

4.  Purchasing  Paper  from  Reputable  Dealers.  Banks  in  buy- 
ing paper  from  brokers  or  dealers  place  considerable  importance 
in  the  character  and  standing  of  these  concerns.  Although 
dealers  do  not  indorse  their  offerings,  reputable  houses  thoroughly 


XIV]  SECURITY  FOR  LOANS  201 

investigate  their  paper  before  selling  it  over  their  name,  and  also 
ordinarily  guarantee  its  genuineness. 

5 .  Single-  and  Double-Name  Paper  Should  Not  Be  Outstanding 
at  the  Same  Time.  When  a  borrower  issues  a  considerable 
amount  of  single-name  paper  for  the  purpose  of  obtaining  dis- 
counts on  purchases  or  in  order  to  finance  other  current  transac- 
tions, his  discounted  bills  receivable  appearing  on  the  statement 
at  the  same  time  should  be  investigated  very  carefully,  for  the 
reason  that  the  indications  are  that  the  borrower  is  not  taking 
advantage  of  all  of  his  discounts  and  is  short  of  working  funds. 
In  order  to  retire  the  original  issue  of  single-name  paper  a  liberal 
amount  of  quick  assets  is  necessary;  receivables  are  among  the 
best  quick  assets  of  a  borrower  and  therefore  should  not  be  sold. 
It  is  also  obvious  that  since  the  single-name  paper  was  sold  to 
pay  current  debts,  no  large  amount  of  bills  payable  should  be 
outstanding  thereafter. 

6.  Use  of  Trade  References.  By  obtaining  information  from 
other  business  concerns  which  have  dealings  with  the  borrower, 
a  bank  can  ascertain  his  credit  standing  in  his  own  particular 
line  of  trade.  Such  information  may  indicate  the  borrower's 
strength  or  weakness  in  regard  to  his  policy  in  taking  purchase 
discounts,  the  payment  of  bills  on  time,  the  use  of  technicalities 
in  avoiding  obligations,  and  the  general  standard  of  his  business 
ethics. 

7.  Use  of  References  of  Other  Banks.  Commercial  banks 
make  a  practice  of  keeping  well  informed  concerning  local  busi- 
ness conditions  and  the  standing  of  business  houses  in  their 
vicinity.  This  information  is  available  for  other  banks  and  is 
constantly  being  made  use  of  in  determining  credit  risks  of  appli- 
cants for  loans.  Special  forms  are  employed  by  banks  for 
answering  requests  for  data  of  this  kind. 

8.  Credit  Statements  by  Borrowers.  To  pass  intelligently  on  an 
application  for  a  loan  from  a  concern  that  does  not  furnish  col- 
lateral, a  bank  must  know  the  amount  of  the  concern's  assets  and 


202  BANKING  AND  CREDIT  [XIV 

their  condition,  the  liabilities,  revenues,  and  expenses,  and  other 
similar  financial  data.  Furthermore,  it  is  highly  desirable  that 
credit  statements  showing  this  information  should  be  prepared 
by  pubhc  accountants,  for  the  reason  that  statements  which  are 
compiled  by  the  borrower,  even  if  there  is  no  question  about 
his  integrity,  tend  to  magnify  assets,  minimize  liabiHties,  and  in 
general  to  exaggerate  points  in  his  favor. 

14.  Open-Market  Operations— Commercial  Paper  Broker. — 

Open-market  operations,  as  generally  understood,  include  trans- 
actions with  commercial  paper  brokers  or  dealers,  finance  com- 
panies, factors,  discount  companies,  or  other  business  firms  not 
engaged  in  a  purely  banking  business,  involving  the  negotiation 
of  loans  and  the  buying  and  selling  of  commercial  paper.  As 
used  in  the  Federal  Reserve  Act,  however,  the  term  "open- 
market  operations "  refers  not  to  rediscounting  but  to  the  pur- 
chase and  sale  by  a  federal  reserve  bank,  either  from  or  to 
domestic  or  foreign  banks,  firms,  corporations,  or  individuals,  of 
cable  transfers  and  bankers'  acceptances  and  bills  of  exchange 
with  or  without  the  indorsement  of  a  member  bank. 

The  commercial  paper  broker  or  dealer  performs  an  important 
function  in  the  financing  of  current  business  transactions.  He 
acts  as  a  go-between  for  the  bank  having  funds  to  invest  and  the 
borrower  needing  accommodation.  Until  the  enactment  of  the 
Federal  Reserve  Act  the  nearest  approach  to  a  discount  market  in 
this  country  was  the  market  created  by  commercial  paper  dealers. 
However,  besides  providing  in  a  measure  a  discount  market  there 
were  and  are  other  good  reasons  for  the  existence  of  paper  dealers. 
In  part  an  explanation  is  to  be  found  in  the  growth  since  the  Civil 
War  of  the  custom  by  merchants  and  manufacturers  of  selling 
their  single-name  promissory  notes  in  the  open  market.  More 
important,  however,  is  the  service  rendered  by  the  commercial 
paper  dealer.  An  efficient  dealer  keeps  closely  in  touch  with  the 
buying  and  selling  needs  of  his  field  and  knows  the  preferences  of 


XIV]  SECURITY  FOR  LOANS  203 

the  banks  and  the  conditions  of  the  borrowers.  By  the  use  of  a 
well-organized  credit  department  he  is  able  to  get  an  accurate 
check  upon  the  quality  of  the  paper  offered,  and  banks  purchas- 
ing it  can  usually  rely  on  its  safety.  By  the  development  of 
dealings  with  regular  clients  the  broker  does  not  need  to  make 
a  new  investigation  at  every  issue  of  paper,  and  the  individual 
borrower  knows  that  he  will  be  properly  cared  for. 

Competition  has  required,  and  the  sale  of  large  quantities 
enables  the  dealer  to  work  on,  a  small  margin.  Most  of  the  leading 
houses,  upon  the  receipt  of  paper  from  the  borrower,  advance  him 
cash  less  the  commission.  In  order  to  provide  themselves  with 
funds,  some  dealers  negotiate  loans  with  their  banks  on  single- 
name  paper  without  collateral  for  sums  amounting,  not  infre- 
quently, to  millions  of  dollars;  other  dealers  with  less  financial 
strength  hypothecate  the  paper  bought  as  security  for  their  notes. 

Dealers  distribute  the  paper  to  banks  through  the  mail  and 
through  traveling  representatives.  Some  dealers  give  banks 
options  extending  from  a  week  to  10  days,  while  others  sell  their 
paper  outright.  None  of  the  dealers  indorse  the  paper,  although 
most  houses  guarantee  its  genuineness.  Whether  or  not  the 
paper  is  guaranteed,  however,  is  not  considered  as  important  by  a 
bank  as  the  standing  of  the  dealer  himself.  When  requested, 
dealers  furnish  banks  with  credit  and  financial  statements  of  the 
borrower  together  with  a  digest  of  the  statements  and  a  list  of 
firms  from  whom  trade  references  may  be  obtained  and  also  any 
banks  that  may  have  handled  his  paper  in  the  past. 

15.  Other  Distributors. — Commission  merchants,  also  known 
as  factors  in  some  lines  like  textiles,  not  only  sell  goods  for  cus- 
tomers and  mills  for  whom  they  act  as  selling  agents,  but  also 
enter  into  arrangements  for  accepting  sellers'  invoice  statements 
dated  ahead  and  book  accounts  on  assignment.  Commercial 
bankers  and  finance  companies  also  make  a  business  of  purchas- 
ing accounts  receivable  as  well  as  loaning  funds  on  the  basis  of 


204 


BANKING  AND  CREDIT 


XTV 


collateral  not  generally  acceptable  to  the  ordinary  commercial 
bank.  Discount  companies'  are  now  being  organized  in  the 
United  States,  and  some  bankers  are  inclined  to  believe  that  it  will 
be  possible  for  them  to  rediscount  paper  with  these  discount 
companies  on  more  favorable  terms  than  with  the  federal  reserve 
banks. 

i6.  Differences  in  Rates  of  Interest  on  Loans. — Discount  and 
interest  rates  vary  according  to  the  character  of  the  loans,  the 
locality,  and  the  condition  of  the  money  market.  This  is  illus- 
trated by  the  quotations  prevailing  in  New  York  City  and  El 
Paso,  Texas,  for  the  30-day  period  extending  from  February  15 
to  March  15,  1921: 

Comparative  Table  of  Interest   Rates  at  New  York  and  El  Paso 


1.  Prime  commercial  paper: 

Customers,  30  to  90  days'.  . 
Customers,  4  to  6  months'. . 
Open  market,  30  to  90  days' 
Open  market,  4  to  6  months' 

2.  Interbank  loans 

3.  Bankers'  acceptances: 

Indorsed,  60  to  90  days' . . . . 
Unindorsed,  60  to  90  days'  . 

4.  Collateral     loans,     stock     ex- 

change, or  other  current: 

Demand 

3  months' 

3  to  6  months' 

5.  Cattle  loans 

6.  Ordinary   loans  to   customers, 

secured  by  Liberty  bonds 
and  certificates  of  indebted- 
ness   


High 


I   4 
3   4 


New  York 


6 
6 

7  1/4 
7  I  '4 
6 

s  3/4 


4  1/4 


7 

7  1/4 

7  1/2 


6-6  1/2 
6  1/8-6  I/: 


High 


El  Paso 


Lev 


Common 


'  See  note   p.  119. 


XIVl 


SECURITY  FOR  LOANS 


205 


17.  Comparison  of  Loans,  Deposits,  and  Capital. — The  fol- 
lowing table  comparing  the  loans,  deposits,  and  capital  (in- 
cluding surplus  and  undivided  profits)  of  national  banks  since 
1870,  illustrates  the  part  which  banks  play  in  dealing  in  credits. 
First,  it  will  be  noted  that  there  is  a  close  correspondence  between 
loans  and  deposits;  second,  that  capital  has  provided  a  diminish- 
ing proportion  of  funds  for  the  loaning  operations  of  the  banks; 
and,  third,  that  in  the  five  years,  191 5-1920,  the  loans  or  credits 
granted  by  the  banks  nearly  doubled.  During  this  latter  period 
banks  enormously  increased  their  deahngs  in  credits.  New 
methods  of  converting  private  credit  into  bank  credit  were  made 
possible  through  the  federal  reserve  system.  Loans  and  dis- 
counts in  this  table  do  not  include  securities  of  any  kind  which 
the  banks  own,  but  simply  the  temporary  loans  and  discounts  to 
individuals,  firms,  and  corporations. 

Comparison  of  Loans,  iNDivmuAL  Deposits,  and  Capital  of  National 
Banks  since  1870 


Loans 

Individual 

Deposits 

Capi 

tal 

Nearest 

Percentage 

Date  to 
June  30 

Amount 
(Millions) 

Percen- 
tage of 
Increase 

Amount 
(Millions) 

Percen- 
tage of 
Increase 

Amount 
(Millions) 

Percen- 
tage of 
Increase 

of  Capital 
to  Loans 

1870 

S719.3 

SS4J.3 

S561.8 

78 

1875 

972.9 

35 

686.5 

2  5 

686.9 

22 

70 

1880 

994V 

2 

833.7 

21 

624.5 

—    9 

63 

1885 

i,2S7.7 

26 

1,106.4 

33 

725.0 

16 

50 

1890 

i,933-5 

54 

1,521.7 

37 

934-5 

29 

48 

1895 

2,016.6 

4 

l,736.C 

14 

987.2 

6 

49 

1900 

2, 62.3. .1 

31 

2,458.1 

42 

1,013-1 

3 

39 

190S 

3.899-2 

49 

3,783.7 

54 

1,406-9 

39 

36 

1910 

5,430.2 

39 

5,287.2 

39 

1.851-0 

32 

34 

1915 

6,660.0 

23 

6,611.3 

23 

2,105.4 

14 

30 

1920 

12,396.9 

86 

14.135-6 

114 

2,622.1 

24 

21 

The  percentage  increases  in  loans  and  deposits  show  a  marked 
similarity,  while  the  contribution  of  capital  as  a  basis  for  loans 


206 


BANKING  AND  CREDIT 


fXIV 


has  for  the  past  25  years  steadily  declined.      In  1920  it  was 
approximately  a  fifth  of  loans  as  compared  with  a  half  in  1895. 

In  order  to  show  the  rapid  changes  which  took  place  in  the 
five  years  of  the  development  of  the  federal  reserve  system,  the 
following  figures  are  given  for  each  of  the  years,  1915-1920: 

Annual  Growth  of  National  Bank  Loans,  Deposits,  and  Capital 

since  iqi5 


Loans 

Deposits 

Capital 

Percentage 

Year 

Amount 
(Millions) 

Per  Cent 

ot 
Increase 

Amount 
(Millions) 

Per  Cent 

of 
Increase 

Amount 
(Millions) 

Per  Cent 

of 
Increase 

of  Capital 
to  Loans 

1915 

S6,66o.o 

S6,6ii.3 

52,105.4 

30 

IQ16 

7,679-2 

15 

8,143.1 

23 

2,103.3 

27 

1917 

8,818.3 

15 

9.521.6 

17 

2,198.6 

4 

25 

1918 

9,620.4 

9 

10,181.8 

7 

2,249.8 

2 

23 

1919 

10,574-8 

10 

1 1,891.1 

7 

2,363.4 

5 

21 

1920 

12,396.9 

17 

14. 135.6 

15 

2,622.1 

>) 

21 

Again  is  seen  the  approximate  agreement  of  changes  in  loans 
and  deposits;  also  the  lagging  increase  in  capital,  and  the  dimin- 
ishing proportion  of  capital  to  loans. 

References 

Fiske,  A.  K.     The  Modern  Bank.     pp.  150-159. 
Harris,  R.  S.     Practical  Banking,     pp.  73-83. 
Holdsworth,  J.  T.     Money  and  Banking,     pp.  264-286. 
Kniffin,  W.  H.     The  Business  Man  and  His  Bank.     pp.  150-166. 

The  Practical  Work  of  a  Bank. 

Contains  technical  explanations,  pp.  205-248. 
Moulton;  H.  G.     Financial  Organization  of  Society,     pp.  384-400. 

Principles  of  Money  and  Banking,     pp.  66-77.  8i-8q. 

Phillips,  C.  A.     Bank  Credit. 

Secured  loans,  with  special  reference  to  loans  secured  by  stocks  and 

bonds,  collateral  warehouse  receipts,  and  mortgages,  pp.  224-234; 

overdrafts,  pp.  235-241 ;  loans  of  country  banks,  pp.  242-252. 


XIV]  SECURITY  FOR  LOANS  207 

Pratt,  S.  S.     Work  of  Wall  Street. 

Chapter  19,  Stock  brokers'  loans. 
Shaw,  A.  W.  and  Co.    Loans  and  Discounts. 

Automobile,  warehouse,  farm,  and  cattle  loans,  pp.  81-1 28.  Written 
from  the  viewpoint  of  the  lending  bank. 
Westerfield,  R.  B.     Banking  Principles  and  Practice.      Vol.  IV.  pp.  833- 

860. 
Willis,  H.  P.     American  Banking,     pp.  23-50. 


CHAPTER   XV 
THE  CREDIT  STATEMENT 

I .  The  Credit  Statement  as  an  Element  in  Credit  Decisions. — 

In  making  commercial  loans  without  collateral,  well-managed 
banks  almost  invariably  require  from  a  prospective  borrower  a 
financial  statement  showing  assets  and  liabilities,  revenue  and 
expenses,  and  other  facts  bearing  upon  the  character  and  condi- 
tion of  the  business.  Partly  responsible  for  the  recent  develop- 
ment in  this  feature  of  banking  practice  is  the  necessity  of  accom- 
panying with  a  financial  statement  commercial  paper  offered  for 
rediscount  at  a  federal  reserve  bank. 

The  degree  of  reliance  placed  upon  the  credit  statement  varies 
greatly  with  different  banks,  but  indications  are  that  it  is  increas- 
ing with  the  progress  in  accounting  knowledge  and  analytical 
experience.  Nevertheless,  it  is  fair  to  say  that  fully  40  to  60  per 
cent  of  the  decision  in  any  credit  risk  rests  upon  other  factors — 
"the  so-called  moral  risk,  the  credit  grantor's  knowledge  of  the 
ability  of  the  management  to  produce  economically,  the  moral 
fibre  of  the  managers,  the  condition  of  the  plant,  general  business 
conditions,  and  other  matters  of  this  kind." ' 

Recent  statistics  of  the  causes  of  business  failures,  indicating 
the  importance  of  incompetence  as  a  dominant  factor,  emphasize 
the  necessity  of  careful  consideration  by  the  lender  of  the  personal 
equation  in  the  borrower.  In  191 2,  Bradstreef s  Journal  ranked 
incompetence  first  among  causes  of  failure  in  the  United  States. 
In  1919,  38.2  per  cent  of  all  failures  were  attributed  to  this  cause, 
while  only  30.3  per  cent  were  charged  to  lack  of  capital,  the  next 


'Alexander  Wall,  "Study  of  Credit  Barometrics,"  Federal  Reserve  Btdleiin,  March  i, 
1919,  p.  230. 

208 


XVI  THE  CREDIT  STATEMENT  209 

largest  cause.    In  1920,  when  credit  was  unusually  tight,  incom- 
petence ranked  equal  in  importance  to  lack  of  capital.^ 

2.  Credit  as  a  Business  Aid. — Another  aspect  of  the  import- 
ance of  the  personal  factor  in  credit-granting  is  well  illustrated 
from  the  observation  of  a  well-known  sales  manager,  who  writes:^ 

One  of  my  associates  sold  rubber  tires  years  ago.  He  sold 
some  goods  to  Henry  Ford,  then  a  poor  struggling  man,  but  the 
big  rubber  company  for  whom  he  was  working  promptly  turned 
the  order  down,  because  the  report  secured  from  the  commercial 
agency  at  the  time  said  something  about  Ford  being  visionary, 
and  of  uncertain  credit.  In  Detroit  there  are  plenty  of  stories  cur- 
rent of  the  inability  of  credit  men  and  bankers  to  measure  Ford 
correctly.    The  country  is  full  of  examples  of  that  sort. 

Arthur  Capper,  one  of  the  largest  new^spaper  proprietors  in 
Kansas,  also  governor  of  that  state  and  now  senator,  is  another 
example.  When  he  started  in  business  he  was  an  impecunious 
printer.  He  had  a  chance  to  buy  the  Topeka  Capital,  one  of  the 
biggest  papers  in  the  West.  He  got  somebody — a  real  credit  man 
or  a  group  of  them — to  back  his  enterprise  with  credit,  and  he  is 
today  one  of  the  most  successful  business  men  in  Kansas. 

Another  illustration.  I  know  of  a  poor  foreign  laborer  who 
started  to  make  steel  barrels  in  a  little  shed,  just  a  few  years  ago. 
He  tried  to  get  credit,  but  could  not.  The  banks  turned  him 
down.  But  an  officer  of  one  of  the  banks  individually  extended 
him  credit.  This  laborer  is  now  a  large  manufacturer,  and  this 
bank  officer  is  one  of  the  leading  officials  in  his  company,  a  proper 
reward  for  credit  vision. 

The  above  illustrations  bring  home  the  value  of  the  personal 
factor,  but  the  impression  should  not  be  gained  that  it  is  generally 
desirable  for  a  bank  to  make  very  many  such  loans.  Banks  which 
fail  are  usually  loaded  with  this  sort  of  paper.  The  financial 
districts  have  an  abundance  of  enthusiastic  and  erratic  geniuses 
who  would  have  the  banks  back  their  projects  to  a    dangerous 


^  Bradstreet's  Journal,  February  s,  192 1,  pp.  5-6. 

3  J.  George  Frederick,  "The  Sales  Manager's  Point  of  View,"  Credit  Monthly,  July 
1920,  p.  IS. 

14 


210  BANKING  AND  CREDIT  [XV 

limit.    Of  course,  occasionally  one  of  these  individuals  proves 
successful,  but  the  vast  majority  do  not. 

3.  Other  Information  Necessary. — Experience  during  1920- 
192 1  shows  the  necessity  of  taking  fully  into  account  the  genera] 
business  situation  and  conditions  in  a  particular  trade,  prospec- 
tive as  well  as  present,  in  arriving  at  a  loan  decision.  Business 
concerns  which  succeed  well  enough  in  ordinary  times  may  be 
utterly  unable  to  weather  a  business  storm ;  and  a  financial  state- 
ment which  is  entirely  satisfactory  at  the  beginning  of  a  crisis 
may  be  extremely  unsatisfactory  at  its  end. 

The  credit  statement  must  therefore  be  regarded  as  but  one 
element  among  several  contributing  to  a  creditor's  decision.  It 
should  be  analyzed  in  the  light  of  other  information,  and  con- 
clusions from  it  should  be  checked  up  by  the  aid  of  evidence  of  an 
entirely  different  character.  Nevertheless,  a  careful  analysis  of  a 
credit  statement  in  suitable  form,  especially  in  comparison  with 
similar  statements  of  earlier  years  and  of  other  concerns,  will 
frequently  yield  evidence  of  competence  or  incompetence,  and  of 
adaptability  or  inadaptability  to  changing  business  conditions, 
which  might  otherwise  be  overlooked.  It  is  because  the  bor- 
rower's statement  is  coming  to  be  regarded  as  an  essential  ele- 
ment in  such  decisions  that  considerable  attention  is  now  being 
given  to  the  problems  involved  in  its  analysis. 

4.  Two  Main  Parts  of  a  Credit  Statement. — The  two  main 
parts  of  a  credit  statement  of  any  business  concern  correspond  to 
its  fundamental  financial  statements  and  are:  (i)  the  balance 
sheet,  sometimes  called  a  ''statement  of  assets  and  liabilities," 
or  a  "statement  of  resources  and  liabilities,"  and  (2)  the  in- 
come sheet,  variously  designated  the  "profit  and  loss  account," 
"income  account,"  "revenue  and  expense  statement,"  etc. 
The  balance  sheet  is  an  accounting  statement  of  the  financial 
condition  at  a  given  moment.    Its  presentation  is  based  on  an 


XV]  THE  CREDIT  STATEMENT  211 

equation  that  what  one  owns  equals  what  one  owes  plus  the  dif- 
ference between  these  two  items,  or  net  worth.  The  same  thing 
expressed  differently  is:  Assets  equal  liabilities  (amounts  due  to 
creditors)  plus  net  worth  (residual  balance  belonging  to  stock- 
holders or  proprietors) .  The  income  sheet  is  a  running  narrative 
of  the  earnings  and  expenses  for  any  given  fiscal  period.  As  op- 
posed to  the  balance  sheet  which  depicts  conditions  at  a  given 
moment,  the  income  sheet  tells  what  has  happened  during  a  given 
period. 

Both  the  balance  sheet  and  the  income  sheet  measure  the 
financial  facts  of  a  particular  enterprise,  but  each  in  its  own  way. 
The  situation  is  somewhat  analogous  to  a  tank  of  water,  the  con- 
tents of  which  are  being  measured  from  time  to  time.  Assuming 
an  inflow  and  an  outflow  pipe,  changes  in  the  volume  of  water 
may  be  determined  either  by:  (i)  comparing  the  actual  level  of 
water  for  different  periods,  or  (2)  comparing  the  total  inflow 
with  the  total  outflow. 

The  balance  sheet  indicates  the  solvency  of  the  business,  but 
gives  no  information  as  to  the  earnings  or  expenses  of  operation. 
The  income  sheet  shows  the  earnings  or  expenses,  but  throws  no 
direct  light  on  the  solvency.  There  is,  however,  one  common  item 
and  connecting  link  between  these  two  statements  and  that  is  the 
figure  of  profit  and  loss  or  surplus.  If  a  business  has  been  ac- 
cumulating a  net  profit  for  a  period  of  years,  as  shown  by  the 
income  sheets,  the  last  instalment  will  appear  on  the  income  sheet 
accompanying  that  year's  balance  sheet,  and  will  also  be  included 
in  the  surplus  which  stands  on  the  liabilities  side  of  the  balance 
sheet. 

It  is  the  general  practice  in  a  credit  statement  to  reproduce 
the  balance  sheet  rather  fully  but  to  give  only  the  more  impor- 
tant items,  such  as  sales  and  expenses,  from  the  income  sheet; 
in  many  cases  not  even  these  are  shown  or  sought  for  by  the  bank. 
Explanation  is  to  be  found  in  the  fact  that  the  all-important  pur- 
pose of  a  bank's  analysis  of  a  credit  statement  is  to  determine  the 


212  BANKING  AND  CREDIT  [XV 

probability  of  the  loan  being  repaid  at  maturity  and  not  the  ul- 
timate solvency  of  the  borrower  or  the  desirability  of  the  concern's 
securities  as  an  investment.  There  is  good  reason  to  believe,  how- 
ever, that  in  the  future  more  attention  will  be  given  to  the  income 
sheet  items  with  particular  reference  to  whether  or  not  the  com- 
pany has  been  making  satisfactory  progress  over  a  period  of  years 
and  has  been  keeping  track  of  its  costs  of  doing  business. 

5.  Essentials  of  a  Well-Prepared  Statement. — Particularly 
important  is  it  that  the  statement  be  of  recent  date,  especially  in 
the  case  of  concerns  whose  sales,  purchases,  receipts,  or  disburse- 
ments are  relatively  frequent  and  large,  or  whose  inventories  are 
subject  to  wide  fluctuations  in  price.  The  statement  should  pref- 
erably have  been  audited  by  public  accountants  who  have  no 
personal  interest  in  the  matter  other  than  their  reputation  for 
accuracy.  In  examining  an  unaudited  statement  not  only  must 
reliance  be  placed  on  the  firm's  integrity  but  recognition  must  be 
taken  of  the  inherent  weakness  of  a  borrower  to  magnify  his 
assets  and  minimize  his  liabilities.  Audited  statements  may  be 
divided  broadly  into : 

1.  Those  in  which  the  certificate  is  based  on  an  examination 

of  the  books  without  personal  supervision  of  inventories 
and  independent  appraisal  of  all  assets  with  the  aid  of 
technical  appraisers  (balance  sheet  audits). 

2.  Statements  verified  with  the  personal  supervision  of  in- 

ventories and  independent  appraisal  of  all  assets  (com- 
plete audits). 

The  value  of  the  two  classes  of  audits  and  their  relation  to  each 
other  depends  to  a  great  extent  upon  the  character  and  magnitude 
of  the  business  involved. 

In  some  cases  method  2  has  advantages  over  method  i.  In 
other  cases,  notably  those  of  large  companies  in  which  personal 
supervision  of  inventories  is  arduous  and  perhaps  impracticable 


XV 


THE  CREDIT  STATEMENT 


213 


Stat  :meot  of Date... 

BusihJEss Address 


To  the  

Foi  th«  puipoic  of  piocuiiiis  uJ  esubliihiog  aedil  (nm  t 

lUteam  of  ■    .    Goanda]  cooditioa  00  the  day  c 

n|    axtae  l)ial  i  ur  duoflc  a 


Bank  of 

;  with  the  above  Bank,  the 


odenigDed  nibmib  the  fottowaig  as  hoof  1 


aad   wt}i«tf  ilcUr 


(FILL  IN  ALL  BLANKS  USING 

-NONE-  WHERE  NECESSARY) 



ASSETS 

UABIUTIES 

CMhoiihaod«»clLiibuA. $ 

Not««  Receivable  ol  cusionim * 

Note*  Parable  foi  ia«fcK«Bdi»« % 

Note*  Payable  uumiml $ 

IZ 

To   olBc«.   A«rto«. 

•locktwlden  and  olhen  $ 

Account*  Receivable  of  cmtometi  (cunent)        $ 

AccounU  Parable  foi  ocTchudiM  (not  due)....) 
Account*  Payable  for  mettKandije  (put  due)....* 

AccepUnce.  cf  eu.tom«.  (on  UdJ  boI  diKOUDted)  $ 

Note*  Parable  lo  caot.oll«d  oi  .ubiidivy  coDcmii  *     

COKOM $ 

BanbAcce   tanc  ■                                                 S 

DepoNt*  of  Moner  witbu*  by  o£c«i  udothcn) 

Dividend*  decluM  aod  payable ) 

Interest  OD  Bead*  due  sod  p*y*Ue $ 

Proviwen  for  Federal  Tax* • $ 

United  Sute>  Government  Kcuribei i 



Life  !o«ur»nce— CmS  iurTend«  »alua $ 

TOTAL  QUICK  ASSETS $ 

Due  from  Controlled  orSub*idi«i7  Conceru  $ 

Fm  meicW»due  % 



TOTAL  CURREf^  UABILmES....$ 

Foi  fcdvuices        $ i 

Due  from  officen,  du«tor»,  «lockhoMcn  lod  ©tWi  $  ^  , . . 

Bonded  Debt $ 

1      Mertcage*  on  Real  E«tale $ 

Chattel  Mortgagea $ 

All  Other  UabiUUe*  (itemize) $ 

CapiUl % 

Building* * 

Prepaid  Expeotei * 

Sarplu. $ 

Patent*  and  Trade  Mark* $ 

Other  A**et»  (ilemiie) $ 

TOTAL          $ 

RoMFve*  (itetnize) $ 

Value  of  mercbandiie  purchased  for  next  teaaon'*  busiae**  and   not 

CofitiDeeol  Ljabilibe* :  EodoiMmenli :'  Note*  Reccinbte,  Tiade  AccepUoce*  tad  Baoke 
Detail* - 


included  in  above  aaset*  or  liahilitie*  $  - 

rAccepiaacei.di*couDledo(*oId  witheDdonemcBtor  guarao(ee,$„, 


Form  16.     (a)  Borrower's  Statement  (face) 


214  BANKING  AND  CREDIT  1  XV 


Aje  lay  of  ihe  sbove  aixtf  pl«lg«d  oi  uiigned  ?    

A|«  toy  o(  (he  above  liabililia  iecu(«d>  

Amount  o(  above  accouob  and  nolei  leccivable  pul  due  or  doubtful  > 

D.teol  loveotory> 

AmouDt  o[  Fire  loiuratKe}     On  nerclundiie,  $ 

Net  Salea,  last  Gical  year  ? 

Crou  Profit,  last  fiscal  yeaf>  _ 

Net  Profit,  last  fiscal  yeai) 

AUUted  concern.  (Name  and  location)* 

II  partnoihip,  when  does  tt  leifflinat«> 

Are  there  any  tuju  f"^'"^  against  you> „ 


EspUnfttitsD  of  U17  item  id  tbia  aUleoiciit  may  b«  mftd*  below 


Form  16.     (b)  Borrower's  Statement  (reverse) 

Ftjrms  of  this  kind  are  furnished  by  the  Federal_  Reserve  Bank  of  Boston  upon  request  of 
member  banks  which  may  wish  them  for  customers. 

and  the  value  of  an  independent  appraisal  of  assets  is  liable  to  be 
considerably  exaggerated,  the  reverse  may  be  true.  It  is  estimated 
that  go  per  cent  of  the  statements  certified  by  public  accountants 
are  balance  sheet  audits.'' 

Although  the  other  specific  requirements  of  well-prepared 
credit  statements  vary  somewhat  under  different  conditions,  the 
statement  form  of  the  Federal  Reserve  Bank  of  Boston  shown  in 
Form  16  illustrates  the  kind  of  information  that  banks  desire. 


■*  Federal  Reserve  Bulletin,  April  i,  1917.  p.  270. 


XV]  THE  CREDIT  STATEMENT  215 

6.  No  Fixed  Rules  of  Interpretation. — In  analyzing  a  credit 
statement  there  are  no  fixed  rules  to  be  followed  or  infallible  tests 
to  be  applied.  This  is  due  in  a  large  measure  to  the  fact  that  each 
merchant  or  manufacturer  has  his  own  system  of  accounting  and 
his  own  method  of  inventorying.  When  he  prepares  a  credit 
statement  for  his  bank  or  note-broker  he  starts  generally  with  the 
ledger  trial  balance,  which  probably  contains  several  hundred 
accounts,  and  condenses  it  into  a  few  items  for  the  statement. 
Very  often  the  bank  will  find  it  necessary  to  make  allowance  for 
depreciation  or  shrinkage  in  value  in  order  to  determine  the 
amount  of  assets  actually  available  for  the  payment  of  current 
debts.  Moreover,  it  may  be  desirable  to  have  accurate  informa- 
tion concerning  obligations  on  account  of  contracts  and  agree- 
ments that  do  not  appear  on  the  conventional  form  of  balance 
sheet.  These  obligations  which  are  common  to  most  business 
concerns  arise  from  the  purchase  of  raw  materials  or  the  sale  of 
finished  goods  for  delivery  at  some  future  date  at  fixed  prices.  In 
the  case  of  specialties  or  luxuries  subject  to  wide  variations  in 
prices,  or  on  a  fluctuating  market  for  staple  commodities,  a  firm's 
obligations  of  this  character  may  cause  serious  embarrassment. 

But  of  no  less  importance  is  the  consideration  of  unfilled  orders 
or  customers'  contracts  which  have  been  canceled.  In  times  of 
falling  prices  or  business  uncertainty,  cancellation  of  contracts 
becomes  a  serious  problem  for  manufacturers.  Although  in  some 
instances  manufacturers  insist  upon  the  terms  of  their  contracts 
with  buyers  and  refuse  to  submit  to  cancellations,  in  the  majority 
of  cases  such  losses  are  unavoidable.  In  general  there  are  four 
good  reasons  why  manufacturers  do  not  as  a  rule  take  legal  action 
against  buyers  who  have  canceled  orders  for  goods.  First  of  all, 
if  the  manufacturer  values  the  good-will  of  his  customer  and  is 
counting  on  future  business  with  him  he  probably  will  not  con- 
sider it  wise  to  force  him  to  take  the  merchandise.  In  the  second 
place,  the  buyer  might  not  be  able  to  market  the  goods,  and, 
consequently,  if  compelled  to  accept  them  he  might  be  forced  into 


2l6  BANKING  AND  CREDIT  [XV 

bankruptcy  or  placed  in  a  position  where  he  could  not  pay  for 
them.  Again,  if  the  seller  insists  upon  his  legal  rights  the  buyer 
may  resort  to  technicalities  and  return  the  merchandise  because  of 
"defective"  material  or  workmanship.  Finally,  legal  procedure 
in  such  cases  is  long  and  expensive  and  is  a  matter  which  most 
business  houses  endeavor  to  avoid. 

7.  Business  Conditions  and  Customs  Affecting  Credit. — In 

judging  a  financial  statement  the  credit  man  will  find  indispens- 
able a  knowledge  of  trade  customs,  such  as  buying  and  selling 
methods,  discounts,  datings,  and  manner  of  extending  credit.  As 
a  general  thing  the  best  class  of  commercial  paper  is  issued  by 
concerns  dealing  in  the  necessities  of  life  and  commodities  having 
a  wide  and  active  market,  and  not  such  as  have  utility  of  a  transi- 
tory character  and  are  subject  to  the  whims  of  fashion.  The  fed- 
eral reserve  banks  look  with  particular  favor  on  paper  based  upon 
readily  marketable  staples.  By  "readily  marketable  staples"  is 
meant  all  raw  products,  such  as  cotton,  grain  and  other  foodstuffs, 
ores,  and  common  chemicals,  which  enjoy  a  broad  market  and 
are  thoroughly  standardized  and  fairly  non-perishable.  No  doubt 
there  are  some  lines  of  manufactured  goods  which  are  sufficiently 
standardized  as  to  methods  of  production,  styles,  uses,  customs, 
and  other  factors,  and  for  which  there  exists  a  broad  enough 
market  to  warrant  their  inclusion  in  a  list  of  readily  marketable 
staples.  It  is  hoped  that  the  Federal  Reserve  Board  in  the  near 
future  will  issue  a  list  of  staples  which  it  considers  readily  market- 
able at  all  times  and  under  all  conditions. 

Usually  the  business  of  the  borrower  is  subject  to  those  influ- 
ences that  affect  allied  and  associated  industries.  For  instance, 
the  market  for  plumbing  supplies  is  dependent  on  building  opera- 
tions, the  market  for  dyes  is  affected  greatly  by  the  activity  in  the 
textile  and  leather  trades,  and  the  demand  for  cement  is  influenced 
by  the  amount  of  road  construction. 

Comparative  statements  covering  a  period  of  years  which  in- 


XV]  THE  CREDIT  STATEMENT  217 

eludes  a  business  depression  as  well  as  a  business  expansion  are 
much  more  significant  than  data  for  any  single  year.  It  is  also 
desirable  to  obtain  figures  for  similar  concerns  in  the  same  section 
and  possibly  different  sections  of  the  country.^  In  examining  a 
credit  statement,  banks  usually  first  transcribe  the  data  to  a 
columnar  sheet  where  comparative  results  for  a  number  of  years 
can  be  studied  and  trends  in  different  directions  can  be  noted. 

8.  Character  of  Quick  Assets. — Jobbers  and  wholesale  mer- 
chants stand  between  the  original  producers  and  the  retailers, 
and  this  fact  has  a  bearing  upon  the  character  of  the  former's 
quick  assets.  For  example,  accounts  receivable  of  a  jobber  or 
a  wholesale  merchant  are  mostly  due  from  retail  merchants,  and 
are  more  easily  collected  than  open  accounts  in  the  retail 
trade.  To  a  large  extent  also,  the  merchandise  is  in  unbroken 
packages  and  is  readily  salable  in  the  event  of  liquidation. 

The  accounts  receivable  of  a  retail  merchant  are  largely  due 
from  individuals  and  allowance  must  be  made  for  loss  in  the 
process  of  collection.  Because  the  merchandise  consists  of  a 
widely  distributed  variety  of  articles  and  finished  goods  with  a 
relatively  narrow  market,  considerable  difficulty  may  be  met  in 
realizing  upon  these  assets  should  it  become  necessary.  For  the 
reasons  given,  the  margin  of  quick  assets  of  a  retail  merchant 
should  be  larger  than  in  the  case  of  a  wholesaler.  This  is  not  to  be 
considered  a  reflection  upon  the  retail  merchant's  paper  but 
simply  an  established  principle  of  credit. 

Manufacturers'  statements  according  to  a  well-recognized 
practice  should  have  sufficient  capital  furnished  by  the  stock- 
holders to  cover  the  investment  in  plant,  machinery,  and  equip- 
ment less  the  bonded  or  mortgage  debt.  The  current  borrowings 
will  be  represented  by  raw  material,  finished  and  unfinished  goods, 
and  current  manufacturing  expenses.    In  the  business  depression 


s  Writings  of  Alexander  Wall  and  publications  of  Robert  Morris  Associates  contain 
information  on  this  point. 


2lS  BANKING  AND  CREDIT  [XV 

of  1920  and  192 1  many  manufacturers  quickly  found  themselves 
in  the  unfortunate  position  of  having  a  small  margin,  if  any,  of 
quick  assets  over  quick  liabilities,  although  their  fixed  assets  were 
often  large. 

The  seasonal  requirements  in  many  lines  differ  greatly.  For 
instance,  department  stores  have  two  fairly  well-defined  seasons 
and  a  well-conducted  business  can  borrow  and  run  out  of  debt 
twice  a  year.  This  is  likewise  true  of  many  concerns  selling  to 
department  stores.  Shoe  manufacturers  should  be  in  a  position 
to  carry  liberal  cash  balances  between  seasons.  Other  lines, 
such  as  the  fur  business,  liquidate  by  the  end  of  December  and 
tire  manufacturers  by  June.  The  lumber  manufacturer  requires 
a  year  to  get  his  cut  ready  for  market,  and  consequently  loans 
to  finance  his  operations  run  fairly  steady  throughout  the  year. 

Such  considerations  as  have  been  mentioned  are  of  material 
significance  because  the  indebtedness  arising  from  the  loan  de- 
pends for  liquidation  on  the  convertibility,  use,  or  operation  of  the 
property  against  which  the  loan  is  incurred. 

References 

Ettinger,  R.  P.,  and  Golieb,  D.  E.     Credits  and  Collections. 

Treating  of  the  construction  and  analysis  of  the  credit  statement; 
illustrated  with  blank  forms.    See  especially  pp.  186-250. 
Knififin,  W.  H.     The  Business  Man  and  His  Bank. 
How  to  prepare  a  statement,  pp.  140-149. 

Commercial  Paper. 

Discussion  of  the  fundamental  points  for  consideration  in  the 
analysis  of  credit  statements  in  general,  pp.  15-48. 

The  Practical  Work  of  a  Bank. 

Deals  with  the  essentials  in  granting  credit,  the  moral  risk,  the 
requirements  of  a  good  credit  statement,  and  the  significance  of 
important  items  in  the  statement.    Analyzes  four  typical  statements; 
PP- 373-502. 
Langston,  L.  H.     Practical  Bank  Operation. 

Describes  operations  of  the  credit  department  of  a  bank,  including 
sources  of  information,  relations  with  borrower  and  determination  of 
a  line  of  credit,  pp.  229-257. 


XVI  THE  CREDIT  STATEMENT  219 

Phillips,  C.  A.     Bank  Credit. 

Bank  borrowers'  statement,  pp.   161-213;  investigating  a  credit 
risk,  pp.  214-223. 
Stockwell,  H.  G.     Net  Worth  and  the  Balance  Sheet. 

Presents  a  precise  and  elementary  discussion  of  financial  statements. 
See  especially  pp.  13-195. 
Westerfield,  R.  B.     Banking  Principles  and  Practice. 

Deals  with  the  work  of  the  credit  department  of  a  bank,  including 
sources  of  information  and  interviews  with  borrowers.  Vol.  IV,  pp. 

935-955- 
Willis,  H.  P.,  and  Edwards,  G.  W.     Banking  and  Business. 

Deals  with  sources  of  credit  information  and  determination  of  line 
of  credit;  discusses  some  of  the  principal  items  in  the  borrower's 
statement;  pp.  112-122. 
Almost  any  standard  book  on  accounting  deals  v  ith  the  analysis  of 
financial  statements.    See  especially: 

Cole,  W.  M.     Accounts,  Their  Construction  and  Interpretation. 

Interpretation  of  balance  sheets,  pp.  104-109. 
Hatfield,  H.  R.     Modern  Accounting,     pp.  35-69. 

Baton,  W.  A.,  and  Stevenson,  R.  A.     Principles  of  Accounting,     pp. 
545-598. 


CHAPTER   XVI 
ANALYSIS  RATIOS 

I.  The  Use  of  Ratios  in  Analysis. — The  specific  tests  that 
may  be  applied  by  a  bank  to  a  credit  statement  rendered  by  an 
appHcant  for  a  loan  are  of  two  kinds :  quantitative  and  qualitative. 
By  qualitative  tests  are  meant  the  examination  of  the  nature  and 
inherent  soundness  of  each  item  appearing  on  the  prospective 
borrower's  statement.  Some  discussion  of  this  is  given  in  the 
following  chapter.  Quantitative  tests  involve  a  determination 
of  certain  ratios  such  as  the  following,  which  will  be  discussed  in 
sequence : 

Current  assets  to  current  liabilities. 

Inventory  to  cost  of  sales  (merchandise  turnover). 

Merchandise  to  receivables. 

Net  worth  to  fixed  assets. 

Sales  to  merchandise. 

Sales  to  receivables. 

Sales  to  net  worth. 

Total  debt  to  net  worth. 

Sales  to  fixed  assets. 

For  the  banker  or  note-broker,  quantitative  tests  are  the  more 
practicable,  and  of  the  various  ratios  used  the  first,  or  the  current 
ratio,  is  by  far  the  most  common.  As  a  general  thing  the  banker 
or  note-broker,  after  satisfying  himself  as  to  the  moral  risk  of  his 
client,  accepts  the  accuracy  of  the  figures  appearing  on  the  credit 
statement  and  concerns  himself  principally  with  the  ratio  of 
current  assets  to  current  liabilities.  Although  the  use  of  the 
current  ratio  as  a  measure  of  the  financial  standing  of  a  business 
firm  is  more  or  less  justified  by  experience,  this  measure  may 


XVI]  ANALYSIS  RATIOS  221 

prove  very  unsatisfactory  in  certain  cases  and  if  employed,  as  it 
is  frequently,  as  the  acid  test  of  a  statement  may  do  injustice  to 
both  the  credit-grantor  and  the  prospective  customer.  Excellent 
work  has  been  done  in  the  development  of  the  technique  of  credit 
analysis  by  Alexander  Wall  and  organizations  like  the  Robert 
Morris  Associates.  Mr.  Wall's  ratio-averages  include  such  items 
as  the  rapidity  of  turnover,  relationship  of  debt  to  net  worth, 
ratios  for  different  industries  and  for  different  sections,  etc. 
Although  the  future  of  credit  analysis  will  probably  witness  pro- 
gress in  the  direction  outlined  by  Mr.  Wall,  to  date  there  are  very 
few  bankers  who  have  found  occasion  to  make  practical  use  of 
these  new  ideas. 

2.  Ratio  of  Current  Assets  to  Current  Liabilities. — The  terms 
"current"  or  "quick."  when  used  in  connection  with  assets  and 
liabilities,  refer  to  cash  items  or  those  that  will  take  the  form  of 
cash  or  its  equivalent  within  a  comparatively  short  time  (ordi- 
narily a  year),  and  distinguish  such  assets  and  liabilities  from  those 
of  a  permanent  or  fixed  character.  To  the  banker  who  is  inter- 
ested most  of  all  in  the  firm's  ability  to  meet  its  current  obliga- 
tions, this  part  of  the  statement  is  of  primary  importance.  In 
the  case  of  a  mercantile  company  bankers  ordinarily  expect  a 
satisfactory  statement  to  show  at  least  a  2  to  i  condition,  or  in 
other  words,  $2  of  quick  assets  to  discharge  $1  of  quick  liabilities. 
This  2  to  I  ratio,  or  50  per  cent  rule,  is  not  an  absolute  standard 
but  simply  a  working  guide.  The  reasoning  behind  this  rule  is 
that  whereas  100  per  cent  of  the  current  liabilities  will  require 
payment  it  is  not  safe  to  count  on  more  than  50  per  cent  of  the 
current  assets  being  converted  into  cash  within  the  same  period 
when  the  liabilities  will  fall  due. 

Concerns  which  have  quick  assets  of  an  exceptionally  liquid 
character  may  not  require  so  large  a  ratio.  For  instance,  the 
business  of  a  packing  house  is  such  that  the  buying  of  raw  materi- 
als can  be  curtailed  at  any  time,  with  the  result  that  a  large  part  of 


222  BANKING  AND  CREDIT  [XVI 

the  assets  can  be  quickly  converted  into  cash.  When  a  statement 
does  not  show  a  margin  of  current  assets  over  current  liabihties, 
one  can  be  justified  in  concluding  that  part  of  the  borrowed  money 
is  being  used  for  the  purchase  of  equipment  or  other  fijced  assets, 
or  for  the  payment  of  debts  contracted  for  fixed  assets.  In  some 
cases,  however,  the  situation  may  be  due  to  recent  large  shrink- 
ages in  inventory  values.  Under  these  conditions  a  conservative 
banker  or  note-broker  will  use  great  care  in  purchasing  the  paper. 

It  is  felt  by  some  bankers  that  the  use  of  the  trade  acceptance 
will  interfere  with  the  so-called  "50  per  cent"  rule.  In  many 
countries  depositors  are  given  two  lines  of  credit,  one  line  of  credit 
based  on  trade  acceptances  and  the  other  line  on  inventories. 
The  banker  examines  the  trade  acceptances  offered  and  if  they 
are  satisfactory,  agrees  to  take  a  large  proportion  of  such  paper 
received  by  the  depositor.  The  banker  then  carefully  considers 
the  character  of  the  inventory  and  its  status  with  respect  to  the 
outstanding  liabilities  and  grants  a  line  of  credit  based  on  these 
facts.  The  line  is  liberal  if  the  inventory  consists  of  staple  prod- 
ucts, and  restricted  if  the  inventory  is  made  up  of  products  that 
are  not  readily  salable. 

Many  foreign  bankers  claim  that  this  is  a  more  scientific  way 
of  extending  credit  than  the  American  method  of  granting  ''50 
per  cent";  and,  moreover,  it  is  pointed  out  that  the  loan  is  based 
on  two  specific  items  in  the  depositor's  statement — first,  the 
trade  acceptances,  which  represent  the  best  form  of  accounts 
receivable,  are  discounted,  and  second,  money  is  loaned  on  the 
depositor's  inventory  considered  in  relation  to  his  liabilities. 
Under  this  system  the  funds  advanced  by  the  banker  are  very 
seldom  used  for  the  purchase  of  machinery  and  equipment,  addi- 
tions to  buildings,  and  for  acquiring  other  fixed  assets — a  thing 
which  sometimes  happens  under  our  system  where  the  banker 
does  not  make  a  close  inquiry  as  to  the  exact  purpose  for  which 
the  money  is  to  be  used. 

Banks  in  this  country  commonly  grant  lumber  dealers  a 


XVI]  ANALYSIS  RATIOS  223 

separate  line  on  the  customers'  paper,  and  discounting  this  does 
not  affect  the  Hne  given  to  them  on  their  straight  paper,  that  is, 
their  own  promissory  notes.  This  is  also  true  of  acceptances.  A 
first-class  concern  presenting  acceptances  from  highly  rated  cus- 
tomers may  be  accommodated  practically  without  limit,  provided 
the  bank  has  the  money  and  sees  no  need  of  contracting  its  loans. 

3.  Merchandise  Turnover. — In  the  retail  trade  the  policy  of 
concentrating  purchases  with  a  few  high-grade  houses,  buying 
often  and  turning  stock  frequently,  is  desirable  because  it  means 
fewer  creditors  and  a  smaller  stock  of  shopworn  and  unsalable 
goods.  It  is  better  for  a  retail  establishment  to  have  as  credi- 
tors a  few  strong  wholesale  houses  which  have  a  real  interest  in 
the  retailer's  success  than  to  have  many  small  creditors  who  are 
apt  to  cause  embarrassment  in  time  of  financial  stringency. 

For  the  purpose  of  illustrating  the  significance  of  "turnover" 
in  the  analysis  of  a  credit  statement,  the  following  balance  sheet 
and  statements  of  fact  are  of  value: 

Central  Shoe  Store 

Boston,  Mass.,  December  31,  1921 

Assets 

Merchandise  inventory $91,500 

Fixtures 6,200 

Accounts  receivable ,S,400 

Cash 1,300 

Total  assets $104.400 

Liabilities 

Accounts  payable  for  merchandise  ($8,500  past  due) $33-500 

Trade  acceptances  (due  in  30  days) 12,000 

Borrowed  from  individuals  on  notes 18,500 

Total  liabilities $64,000 

Proprietor's  net  worth 40,400 

Total  liabilities  and  net  worth $104,400 


224  BANKING  AND  CREDIT  [XVI 

Sales  for  year  ended  December  31,  1921 $116,800 

Purchase  price  of  goods  sold $92,000 

Clerk  hire 2,250 

Rent 15.500 

Expense 3.000       112,750 

Net  profit  before  personal  withdrawals $4,050 

Personal  withdrawals 3. 600 

Net  profit  after  personal  withdrawals $450 

Average  merchandise  inventory  for  year  at  cost $92,800 

Analysis  of  this  statement  shows  that  the  purchase  price  of 
the  goods  sold  during  the  year  amounts  to  $92,000  and  that  the 
average  merchandise  inventory  for  the  year  is  $92,800.  Ob- 
viously the  merchant  has  turned  his  stock  only  once  during  the 
year.  If  the  turnoverwere  between  two  and  three,  as  it  probably 
should  be,  the  proprietor  would  carry  a  stock  of  merchandise  of 
approximately  $30,000  instead  of  $92,800  and  would  be  able  to 
liquidate  at  once  almost  his  entire  indebtedness.  As  it  is,  the 
monthly  receipts  are  in  the  neighborhood  of  $9,700.  From  this 
figure  must  be  subtracted  the  monthly  charge  for  clerk  hire,  rent, 
and  expense,  of  approximately  $1,700,  and  there  is  left  $8,000 
(before  allowing  for  personal  withdrawals),  which  simply  means 
that  it  will  require  the  receipts  of  about  8  months  to  pay  the 
debts. 

The  number  of  times  that  stock  is  turned  over  each  year  has  a 
significant  relation  to  the  time  within  which  commercial  paper 
should  mature.  If  the  yearly  turnover  in  a  certain  mercantile 
establishment  is  4,  it  means  that  on  an  average  3  months  are 
required  to  sell  a  particular  lot  of  goods.  Therefore,  since  com- 
mercial paper  depends  for  its  liquidation  upon  the  convertibility 
of  the  merchandise  back  of  it,  the  paper  of  this  firm  ordinarily 
should  run  for  not  more  than  90  days. 

In  many  cases  turnover  is  misunderstood.  For  instance,  a 
merchant  carrying  a  stock  of  $10,000  and  doing  an  annual  busi- 
ness of  $  100,000  is  apt  to  be  misled  with  the  idea  that  he  has  turned 


XVI  ]  ANALYSIS  RATIOS  225 

his  stock  10  times.  The  error  in  the  calculation  is  due  to  the  fact 
that  the  turnover  has  been  figured  on  sales,  whereas  the  stock  is 
based  on  cost. 

Turnover  may  be  figured  correctly  according  to  either  of 
two  methods :  one  involves  a  calculation  with  the  cost  of  stock  and 
the  cost  of  gross  sales;  the  other  on  the  basis  of  value  of  stock 
figured  at  sales  price  together  with  total  sales.  If  we  assume 
that  in  the  case  above  mentioned  the  merchant  has  realized  a 
net  profit  of  2)2^3  per  cent,  he  has  turned  his  stock  6.67  times 
and  not  10  times,  as  might  be  at  first  believed.  The  following 
illustrations  are  self-explanatory: 

Based  on  cost: 

Cost  of  average  merchandise  inventory $10,000.00 

Cost  of  sales  ($100,000  less  33  1/3%  profit) 66,666.67 

Turnover 6.67  times 

Based  on  sales  price: 

Sales  price  of  $10,000  average  merchandise  inventory . .  .  $15,000.00 

Total  sales 100,000.00 

Turnover 6.67  times 

4.  Ratio  of  Merchandise  to  Receivables. — This  ratio  is  ob- 
tained by  dividing  the  total  merchandise  inventory  by  the  sum  of 
the  accounts  and  bills  (notes)  receivable.  The  resulting  figure  is 
an  index  of  the  dollars  of  receivables  there  are  for  every  dollar  of 
merchandise  on  hand.  It  is  the  general  practice  to  carry  mer- 
chandise on  the  balance  sheet  at  cost  or  market,  whichever  is  the 
lower.  Accounts  and  bills  receivable,  however,  represent  selling 
price.  The  sale  of  merchandise  therefore  tends  to  increase  the 
current  ratio  in  favor  of  current  assets.  A  comparison  of  the  ratio 
of  receivables  to  merchandise  for  different  periods  will  indicate 
whether  or  not  current  assets  include  a  greater  proportion  of 
profits  as  a  result  of  conversion  of  merchandise  into  receivables. 
If  this  proportion  be  greater  it  might  be  contended  that  the  cur- 
rent ratio  should  show  an  increase  if  the  same  financial  strength  is 
to  be  maintained.    No  doubt  this  theory  has  some  merit,  but, 


226 


BANKING  AND  CREDIT 


XVI 


particularly  in  a  period  of  depression,  the  fact  that  a  concern  is 
able  to  market  some  considerable  part  of  its  merchandise  at  a 
profit  is  more  important  than  the  ratio  of  merchandise  to  receiv- 
ables. The  following  examples  containing  two  comparative 
statements  which  differ  only  in  that  $50,000  of  merchandise  in 
(a)  has  been  converted  into  $75,000  of  receivables  and  $25,000 
of  surplus  or  profit  in  (b)  will  illustrate  the  point: 


The  X  Y  Z  Company 

(a)  (b) 
Before  Conversion      After  Conversion 

Assets  of  Merchandise          of  Merchandise 

Cash $60,000  $60,000 

Receivables 100,000  175,000 

Merchandise 250,000  200,000 

Current  assets $410,000  $435,000 

Plant  and  equipment 600,000  600,000 

Other  assets 90,000  90,000 

Total  assets $1,100,000  $1,125,000 

Liabilities 

Notes  payable $125,000  $125,000 

Trade  acceptances 15,000  15,000 

Accounts  payable 45,000  45,000 

Accrued  taxes,  wages,  etc 20,000  20,000 

Current  liabilities $205,000  $205,000 

Bonded  debt 100,000  100,000 

Total  debt $305,000  $305,000 

Capital  stock 500,000  500,000 

Surplus 295,000  320,000 

Total  Habilities $1,100,000  $1,125,000 

410,000  4^5,000 

Current  ratio =  200  per  cent  =212  per  cent 

205,000  205,000 

Whereas  the  current  ratio  in  (a)  is  200  per  cent  it  has  been 

increased  to  212  per  cent  in  (b)  solely  as  the  result  of  $50,000 


XVI]  ANALYSIS  RATIOS  227 

worth  of  merchandise  being  sold  for  $75,000,  the  $25,000  profit 
being  carried  in  the  surplus  account. 

5.  Ratio  of  Net  Worth  to  Fixed  Assets. — Toobtain  this  ratio 
net  worth  is  divided  by  the  total  fixed  or  capital  assets.  The 
resulting  figure  indicates  the  proportion  of  the  stockholders'  or  the 
proprietors'  investment  in  plant  and  equipment  or  other  fixed 
assets.  Ratio  of  net  worth '  to  fixed  assets  also  serves  to  measure 
plant  expansion.  The  net  worth  of  a  concern  may  show  a  large 
increase  during  a  certain  year  as  a  result  of  profitable  business. 
What  is  done  with  these  profits,  however,  is  of  considerable  im- 
portance to  the  bank  negotiating  the  loan.  If  all  the  increase  is 
turned  back  into  buildings  and  equipment,  there  is  taking  place  a 
conversion  of  liquid  into  fixed  capital,  and  this  would  be  shown  in 
a  falling  ratio  of  net  worth  to  fixed  assets.  There  is  also  the  dan- 
ger that  the  profits  which  went  into  plant  development  may  have 
been  only  apparent  or  book  profits  gained  through  the  increasing 
prices  of  raw  material  rather  than  realized  profits  from  the  sale 
of  manufactured  goods.  Too  rapid  expansion  of  plant  is  most 
likely  to  occur  in  a  period  of  rising  prices  and,  unless  the  undue 
development  is  checked,  there  usually  results  at  a  later  period 
idle  capital  and  increased  overhead  expense. 

6.  Ratio  of  Sales  to  Merchandise. — This  ratio  is  the  result  of 
dividing  the  net  sales  for  the  year  by  the  total  merchandise  in- 
ventory at  the  beginning  of  the  year.  It  shows  the  dollars  of  sales 
for  every  dollar  tied  up  in  inventory.  Although  alow  ratio  of 
sales  to  merchandise  may  be  the  result  of  large  purchases  in  anti- 
cipation of  higher  prices,  it  is  more  likely  to  indicate  a  consider- 
able stock  of  unsalable  goods.  When  this  and  the  following  ratio 
(section  7)  are  compared  year  by  year,  light  is  thrown  on  signifi- 
cant changes  in  the  liquidity  of  the  assets  or  in  the  current  ratio. 

'  In  the  case  of  a  corporation  net  worth  is  equal  to  the  total  sum  of  the  capital  stock, 
surplus,  undivided  profits,  and  reserves  of  the  nature  of  surplus.  Net  worth  of  a  partnership 
is  represented  by  the  partners'  capital  and  drawing  accounts.  Net  worth  of  a  single  proprie- 
tor is  represented  by  his  capital  account. 


228  BANKING  AND  CREDIT  [  XVI 

The  ratio  of  sales  to  merchandise  is  not  as  significant  as  turnover 
and  differs  only,  when  compared  year  by  year  with  the  latter, 
inasmuch  as  mark-up  and  cost  of  doing  business  have  been  in- 
cluded. These  last  two  items  may  fluctuate  in  different  years  and 
consequently  make  this  ratio  of  little  value. 

7.  Ratio  of  Sales  to  Receivables. — To  obtain  this  ratio  net 
sales  for  the  year  are  divided  by  the  total  of  the  accounts  and  bills 
receivable  at  the  beginning  of  the  year.  The  resulting  ratio  indi- 
cates the  dollars  of  sales  per  year  for  every  dollar  of  receivables 
carried  on  the  books.  This  may  be  a  test  of  the  efficiency  of  the 
credit  and  collections  departments,  though  general  business 
conditions  would  affect  the  situation.  As  the  ratio  increases,  the 
length  of  the  collection  period  decreases.  The  shorter  the  credit 
terms  and  the  closer  collections  are  made,  the  less  chance  there 
will  be  for  loss  through  bad  debts  or  slowness  on  account  of  busi- 
ness depressions;  that  is,  the  larger  the  sales  in  proportion  to  the 
receivables,  the  greater  will  be  the  liquidity  of  those  receivables. 

8.  Ratio  of  Sales  to  Net  Worth.— This  ratio  is  the  result  of 
dividing  net  sales  by  the  net  worth  at  the  beginning  of  the  period 
covered  by  the  sales.  It  indicates  the  dollars  of  sales  for  every 
dollar  of  invested  capital  of  stockholders,  partners,  or  other  pro- 
prietors. A  business  may  be  doing  too  much  or  too  little  business 
in  proportion  to  the  funds  invested  in  it.  If  the  capital  invest- 
ment is  being  turned  over  very  slowly  this  may  be  an  indication 
of  decay  in  the  business  structure.  On  the  other  hand,  a  very 
high  ratio  would  probably  indicate  an  overexpansion  of  business 
operations.  A  ratio  of  this  kind  is  principally  of  value  in  compar- 
ing conditions  in  the  same  concern  for  dift'erent  periods  and  in 
supplementing  other  existing  information. 

9.  Ratio  of  Total  Debt  to  Net  Worth.— By  dividing  the  total 
debt  by  the  net  worth  a  ratio  is  found  which  serves  to  throw  light 


XVII  ANALYSIS  RATIOS  229 

on  the  proportion  that  exists  between  the  funds  loaned  to  the 
concern  and  the  capital  invested  by  the  stockholders,  partners, 
or  other  proprietors.  As  the  proportion  of  total  debt  increases, 
the  concern  becomes  more  dependent  upon  the  decisions  of  its 
creditors,  particularly  in  times  when  there  are  urgent  financial 
problems.  Moreover,  an  increased  ratio  of  debt  to  net  worth 
makes  it  necessary  for  creditors  to  place  greater  reliance  on  the 
moral  risk  of  the  personnel.  Generally  speaking,  an  unduly  high 
ratio  will  cause  the  conservative  credit  man  to  investigate  the 
risk  rather  closely. 

10.  Ratio  of  Sales  to  Fixed  Assets. — This  ratio  is  the  result  of 
dividing  the  net  sales  by  the  total  fixed  assets  at  the  beginning  of 
the  year.  It  indicates  the  dollars  of  net  sales  for  each  dollar 
invested  in  plant  and  equipment  and  other  non-current  assets 
and  therefore  throws  light  upon  the  rapidity  with  which  the  fixed 
capital  is  being  turned  over.  Ratio  of  net  sales  to  fixed  assets  is 
more  significant  when  used  to  supplement  ratio  of  net  worth  to 
fixed  assets  (see  section  5).  If  the  ratio  of  net  worth  to  fixed 
assets  and  the  ratio  of  net  sales  to  fixed  assets  are  both  decreasing, 
or  if  they  are  below  normal,  the  conditions  can  probably  be  ex- 
plained by :  (i)  plant  development  which  is  going  on  more  rapidly 
in  proportion  than  increase  in  net  worth,  and  by  (2)  failure  of 
sales  to  keep  pace  with  growth  in  capital  investments  in  plant 
and  equipment.  In  a  situation  of  this  sort  the  immediate  need 
would  seem  to  be  increased  production  rather  than  plant  expan- 
sion. 

1 1 .  Judgment  in  Interpretation  of  Ratios. — The  proper  use  of 
ratios  in  analyzing  credit  statements  requires  good  judgment  for 
the  reason  that  not  infrequently  the  divisor  or  dividend  is  a 
fluctuating  figure  and  may  be  at  a  high  or  low  point  when  the 
balance  sheet  is  issued.  Many  banks  request  information  as  to 
when  stocks  of  merchandise  are  at  their  highest  point,  when 


230  BANKING  AND  CREDIT  [  XVI 

at  the  minimum,  when  current  liabilities  are  greatest,  and 
other  similar  data.  Many  concerns  show  a  surprisingly  different 
statement  in  July  than  in  January  with  reference  to  the  various 
ratios.  This  is  so  much  so  that  banks  are  trying  to  educate  their 
customers  to  make  inventory  statements  twice  a  year.  Concerns 
which  are  heavy  borrowers  often  furnish  their  bank  with  a  state- 
ment each  month,  estimating  their  merchandise  by  adding  to  the 
previous  inventory  purchases  and  deducting  sales  less  estimated 
profit,  or  by  means  of  a  perpetual  inventory. 

References 

Wall,  A.     Analytical  Credits. 

This  presents  an  analysis  which  attempts  to  apply  to  a  particular 

business  the  law  of  averages  derived  from  studying  the  ratios  of  many 

establishments  grouped  as  to  industry  and  location.    Illustrated  with 

blank  forms,     pp.  92-232. 

Bankers'  Credit  Manual,     pp.  57-135. 

Note:     See  also  references  at  the  end  of  Chapter  XV.      Each  of  the  books 

mentioned  contains  data  dealing  with  the  ratio  of  quick  assets  to 

current  liabilities. 


CHAPTER  XVII 

INDIVIDUAL  ITEMS  OF  A  CREDIT  STATEMENT 

1.  Current  Assets. — In  the  previous  chapter  there  were  pre- 
sented the  broader  considerations  involved  and  the  more  impor- 
tant specific  tests  to  be  applied  in  the  analysis  of  a  credit  statement. 
It  was  also  pointed  out  that  the  banker  or  note-broker  who  has 
satisfied  himself  as  to  the  moral  responsibility  of  the  applicant  for 
a  loan  does  not  as  a  rule  question  the  mathematical  accuracy  of 
the  figures  in  the  statement.  The  chief  purpose  of  this  chapter  is 
to  bring  out  the  significance  of  the  individual  items  comprising  a 
credit  statement  so  that  a  more  thorough  understanding  of  the 
whole  may  be  obtained.    Current  assets  will  be  considered  first. 

2.  Cash. — Although  from  the  viewpoint  of  the  stockholder  of 
a  corporation  a  small  cash  balance  or  even  possibly  a  bank  over- 
draft may  be  more  desirable  than  a  large  idle  cash  fund ,  neverthe- 
less the  banker  who  is  extending  credit  is  interested  in  seeing  the 
cash  account  large  enough  to  provide  for  current  operations. 

Many  business  establishments  are  conducted  at  times  on  so 
close  a  margin  that  any  error  in  calculation  leads  to  financial 
difficulties,  as  for  instance,  the  inability  to  meet  a  note  or  the 
pay-roll  when  a  remittance  from  a  customer  has  been  unex- 
pectedly delayed.  It  is  possible  that  a  concern  expects  to  make 
large  cash  payments  within  a  few  days  after  rendering  its  state- 
ment and  therefore  it  is  desirable  to  know  whether  or  not  such  are 
anticipated. 

Just  what  the  immediate  cash  requirements  of  a  firm  are,  varies 
in  different  lines  of  industry.  Concerns  handling  merchandise  on 
a  strict  consignment  basis  do  not  have  the  same  cash  problems  as 
the  ordinary  mercantile  establishment  for  the  reason  that  pay- 

231 


232  BANKING  AND  CREDIT  [  XVII 

ment  for  the  merchandise  is  not  required  until  it  is  sold.  Firms 
also  that  are  engaged  in  selling  goods,  such  as  musical  instru- 
ments, that  involve  a  relatively  small  expense  for  clerk  hire  and 
other  sales  costs,  can  operate  with  a  comparatively  small  amount 
of  cash.  Finally,  what  the  low  level  of  the  cash  account  should  be 
depends  to  a  very  great  extent  on  the  character  of  the  other  quick 
assets  and  the  relation  of  all  of  them  to  the  firm's  liabihties. 
Obviously  the  more  liquid  the  other  quick  assets,  the  more  readily 
it  will  be  possible  to  convert  them  into  cash  and  with  this  greater 
potential  power  of  convertibility  the  less  actual  cash  is  needed. 

Most  commercial  banks,  when  making  loans,  require  their 
customers  to  keep  on  deposit  a  minimum  average  balance  of  20 
per  cent  of  the  amount  of  the  loans,  and  are  not  inclined  to  extend 
credit  thereafter  unless  this  informal  understanding  has  been 
observed. 

It  is  highly  advisable  for  the  lending  bank  to  be  informed  as 
to  whether  the  cash  account  contains  any  unusual  items,  such  as 
expense  vouchers  or  lOU's  of  officers  of  the  company  or  time 
certificates  of  deposit  which  have  been  used  as  collateral  against 
existing  loans.  In  the  case  of  statements  audited  by  high-class 
firms  of  public  accountants  it  can  usually  be  assumed  that  atten- 
tion will  be  called  to  items  of  this  character.  Ordinarily  the  cash 
item  can  be  verified  very  easily  by  a  bank  making  a  direct  loan, 
as  it  is  in  a  position  to  demand  from  the  borrower  a  list  of  his 
depositories  and  also  the  amount  of  loans  with  other  banks,  if 
any.  These  figures  can  be  checked  by  communicating  with  the 
other  bank  creditors. 

3.  Notes  Receivable  (Bills  Receivable). — It  is  desirable  in  a 
carefully  prepared  credit  statement  to  show  the  notes  receivable 
account  in  detail,  so  as  to  indicate  among  other  things:  (i)  notes 
from  customers  obtained  only  in  the  regular  course  of  business; 
(2)  notes  from  affiliated  concerns;  (3)  notes  from  officials  and 
employees;  (4)  notes  receivable  which  have  been  discounted  at 


XVII 1  ITEMS  OF  A  CREDIT  STATEMENT  233 

the  bank;  (5)  notes  receivable  past  due;  and  (6)  description  of 
collateral  if  any. 

The  notes  receivable,  also  commonly  called  "bills  receivable," 
should  not  ordinarily  be  a  large  item.  A  large  amount  of  notes 
receivable  from  customers  indicates  that  many  of  the  customers 
are  not  of  high  grade,  for  example,  retail  dealers  who  are  short  of 
ready  cash  and  have  been  obliged  to  give  their  promises  to  pay 
for  merchandise.  Sometimes  a  large  item  for  notes  receivable 
reflects  unfavorable  business  conditions  in  the  company's  locahty. 
When  the  notes  receivable  represent  promises  to  pay  by  officers 
and  employees  of  subsidiary  or  affiliated  companies,  the  amount 
of  such  notes  should  be  withdrawn  from  quick  assets  in  the  ab- 
sence of  good  reasons  to  the  contrary.  In  other  words,  notes 
receivable  should  be  restricted  to  paper  that  represents  actual 
sales  of  merchandise. 

Notes  receivable  which  have  been  discounted  at  the  bank 
constitute  a  contingent  liability  on  the  basis  of  the  company's 
indorsement,  and  indication  of  this  fact  should  be  made  on  the 
statement.  One  good  method  of  accomplishing  this  purpose  is 
to  show  on  the  one  side  of  the  balance  sheet  under  the  general 
heading  of  notes  and  accounts  receivable  the  item,  "Notes  re- 
ceivable discounted  or  sold  with  indorsement  or  guaranty"; 
and  on  the  other  side  to  show  under  the  general  heading  of  secured 
liabihties  the  item,  "Notes  receivable  discounted  or  sold  with 
indorsement  or  guaranty  {contra)  y  Both  items  will  appear  ex- 
actly the  same  in  amount.  Another  method  of  securing  some- 
what the  same  results  is  to  reduce  the  notes  receivable  account 
by  the  amount  of  those  discounted  and  to  call  attention  to  the 
contingent  liability  in  a  footnote  appended  to  the  balance  sheet. 

When  notes  receivable  are  secured  by  collateral  such  as 
stocks  and  bonds  or  real  estate,  it  is  usually  an  indication  that 
the  company  does  not  feel  certain  about  being  able  to  collect  the 
item  promptly.  Notes  receivable  that  represent  overdue  or  un- 
collectible accounts  are  doubtful  assets  because  there  is  very 


234  BANKING  AND  CREDIT  [XVII 

little  reason  why  a  concern  should  take  a  customer's  note  in 
settlement  of  an  account  that  is  good. 

In  certain  lines  of  business  the  item,  notes  receivable,  should 
be  very  small  indeed  due  to  trade  custom,  and  if  it  is  large  a 
careful  investigation  is  desirable.  For  instance,  in  the  case  of 
firms  dealing  in  plumbing  supplies,  wholesale  dry  goods  houses, 
department  stores  and  retail  establishments  in  general,  the  stand- 
ard form  of  credit  is  the  open  book  account.  Wholesalers,  how- 
ever, are  gradually  supplanting  some  of  their  open  accounts  with 
trade  acceptances. 

4.  Accounts  Receivable. — Accounts  receivable  are  simply 
book  accounts,  sometimes  called  "open"  accounts,  with  the  cus- 
tomers of  the  concern.  An  analysis  of  this  item  calls  first  of  all 
for  a  knowledge  as  to  whether  the  terms  of  sale  allow  the  cus- 
tomers 30  or  60  days  or  some  other  period  within  which  to  make 
payment.  By  dividing  the  total  yearly  sales  by  the  amount  of  the 
accounts  receivable  it  is  possible  to  determine  with  reasonable 
accuracy  whether  or  not  collections  are  being  promptly  made. 
For  example,  suppose  that  the  terms  of  sale  of  a  certain  house 
average  approximately  45  days  and  that  the  accounts  receivable 
amount  to  $80,000  and  sales  total  $650,000.  In  this  case  the  sales 
are  about  eight  times  as  large  as  the  accounts  receivable  which 
means  that  outstanding  accounts  are  not  more  than  i>2  months' 
sales,  and  indicates  that  customers  are  meeting  their  obligations 
promptly.  If  a  firm  is  selling  on  30  days'  credit  and  has  on  its 
books  one-third  of  the  year's  sales,  it  is  evident  that  the  collec- 
tion methods  or  class  of  the  customers  are  not  of  the  best.  Forty- 
five  days'  sales  would  reflect  a  much  better  and  quite  satisfactory 
condition. 

Accounts  receivable  are  generally  listed  as  accounts  not  due 
and  accounts  past  due.  Accounts  receivable  as  a  whole  are  some- 
times divided  into  good  and  doubtful,  though  the  latter  are  almost 
always  found  in  the  past-due  list.    The  character  of  outstanding 


XVII  I  ITEMS  OF  A  CREDIT  STATEMENT  235 

balances  should  be  carefully  investigated,  because  it  not  infre- 
quently happens  that  while  a  customer  may  be  making  regular 
pa>Tnents  on  his  account,  old  items  which  have  been  in  dispute 
for  a  considerable  period  of  time  are  being  held  in  abeyance. 

Sums  due  on  open  account  from  directors,  officers,  or  em- 
ployees of  the  company  are  not  of  the  same  character  as  trade 
accounts  and  should  not  be  included  under  current  assets.  This 
applies  also  in  the  case  of  deposits  as  security,  guaranties,  and 
other  special  items  not  directly  connected  with  sales. 

Balances  due  on  account  from  subsidiary  or  affiliated  concerns, 
which  may  be  operating  as  branches  in  the  case  of  distributors,  or 
as  producers  in  the  case  of  manufacturers,  must  not  be  included 
in  the  same  item  as  customers'  accounts,  even  if  arising  as  a  result 
of  trading  transactions.  Frequently  subsidiary  and  affiliated 
companies'  accounts  represent  the  actual  working  capital  or  funds 
advanced  by  the  parent  organization,  and  although  such  ac- 
counts may  be  liquidated  from  time  to  time,  they  are  more  or  less 
of  a  fLxed  character  and  should  preferably  be  excluded  from 
quick  assets.  Where  branch  distributors  or  manufacturing  plants 
are  not  separately  incorporated,  no  indebtedness  of  any  kind  with 
the  main  office  should  appear  as  an  asset.  The  merchandise, 
cash,  or  advances  that  may  have  been  made  to  the  branch  are 
simply  subdivisions  of  the  resources  of  the  company  as  a  whole 
and  should  be  treated  as  such  in  the  balance  sheet. 

Trade  discounts  (and  also  so-called  "cash  discounts,"  if  ex- 
ceeding I  per  cent)  and  freights  allowed  by  the  concern  are 
important  matters  for  consideration.  If  such  items  have  been  in- 
cluded in  accounts  receivable,  although  it  is  not  the  general  prac- 
tice to  handle  trade  discounts  in  this  manner,  a  reserve  to  offset 
them  should  be  listed  under  current  liabilities  (or,  what  is  equiva- 
lent, be  shown  as  a  deduction  under  quick  assets) .  Cash  discounts 
in  practice  are  seldom  deducted  from  receivables  and  amount  in 
some  lines  to  5  per  cent.  It  is  also  necessary  to  obtain  information 
regarding  customers'  claims  for  rebates,  allowances  because  of 


236  BANKING  AND  CREDIT  XVII 

defective  material,,  and  reductions  in  prices,  in  order  to  determine 
whether  sufficient  provision  has  been  made  for  these  items  in  the 
statement. 

No  matter  how  promptly  the  customers  of  a  company  may 
meet  their  obligations,  it  is  usually  necessary  to  provide  for  a 
certain  percentage  of  doubtful  or  uncollectible  accounts.  This  is 
accomphshed  by  setting  up  a  reserve  for  bad  debts  which  is 
shown  on  the  balance  sheet,  preferably  on  the  assets  side,  as  a 
deduction  from  accounts  receivable,  or  else  on  the  liabilities  side 
as  a  separate  item.  Normal  loss  will  determine  the  extent  to 
which  it  is  necessary  to  provide  for  bad  or  doubtful  accounts, 
and  this  is  a  matter  which  naturally  varies  in  different  lines  of 
business.  In  some  cases  a  reserve  equal  to  i  per  cent  of  accounts 
receivable  may  prove  adequate,  whereas  in  other  cases  3  per  cent 
may  be  insufficient. 

As  an  evidence  of  the  fact  that  bad  debts  are  ordinarily  just 
as  unavoidable  as  many  other  expenses  in  a  concern  doing 
business  on  open  account,  a  well-known  sales  manager  has  been 
quoted  as  stating  that  he  would  "  fire  "  a  credit  manager  who  suc- 
ceeded in  reducing  bad  debts  to  zero,  implying,  of  course,  that 
such  a  policy  would  be  so  strict  as  to  drive  away  many  customers. 

Inquiry  must  be  made  as  to  whether  any  of  the  accounts 
receivable  have  been  hypothecated  or  assigned,  and  if  so  the 
balance  sheet  should  indicate  the  fact.  Numerous  private 
bankers  and  other  houses,  and  to  some  extent  regular  commercial 
bankers,  make  it  a  business  to  loan  to  concerns  on  their  accounts 
receivable,  or  more  exactly  to  purchase  these  debts,  particularly 
in  the  case  of  manufacturers  and  wholesalers.  Accounts  can  be 
assigned  openly  by  notifying  the  customers,  or  arrangements  can 
be  made  so  that  customers  do  not  know  that  their  accounts  have 
been  sold.  When  accounts  receivable  have  been  assigned  or 
pledged,  they  are  no  longer  an  asset  and  should  not  be  classed  as 
such.  Moreover,  until  they  have  been  settled  they  remain  a 
contingent  liability  for  their  ultimate  payment  and  therefore 


XVII  ]  ITEMS  OF  A  CREDIT  STATEMENT  237 

this  fact  should  be  shown  on  the  balance  sheet  either  as  an  ap- 
pended note  or  under  the  general  heading  of  secured  liabilities 
bearing  the  caption,  ''Customers'  accounts  discounted  or  as- 
signed {contra).'" 

5.  Merchandise. — Merchandise,  including  in  the  term  fin- 
ished product,  goods  in  process,  and  raw  material,  often  con- 
stitutes the  major  portion  of  current  assets  and  is  the  most 
difficult  of  them  to  appraise  correctly.  It  has  become  the  cus- 
tom to  insist  that  merchandise  be  inventoried  either  at  cost  or  at 
market  price,  whichever  is  the  lower.  The  purpose  of  this  policy 
is  to  prevent  the  inflation  of  the  assets  by  the  recording  of  profits 
before  they  are  actually  realized  through  the  sale  of  the  goods. 
When  the  market  price  is  below  cost  some  credit  men  and  ac- 
counting firms  are  of  the  opinion  that  cost  less  the  usual  profit 
should  be  the  inventory  figure,  that  is,  if  an  article  has  been  pur- 
chased for  $1  to  sell  at  a  20  per  cent  profit  (figured  on  selling 
price)  and  the  retail  market  price  falls  to  $1,  the  proper  inventory 
figure  would  be  80  cents.  Deduction  of  the  profit  is  to  be  justified 
principally  because  of  the  further  shrinkage  in  value  due  to  selling 
and  administrative  expenses  properly  chargeable  against  gross 
profits  from  merchandise. 

Continuing  on  this  point  one  writer  states: 

When  we  consider,  however,  the  next  economic  step  in  manu- 
facture and  distribution,  the  book  account,  or  the  bills  receivable, 
we  do  not  find  that  this  cost  proposition  exists.  We  do  not  hear 
it  argued  that  the  accounts  and  bills  receivable  should  be  carried 
on  the  statement  at  cost;  and  there  is  a  large  question  as  to 
whether  or  not  such  a  plan  would  be  feasible,  equitable,  or  even 
possible.  We  are  then  confronted  with  the  fact  that,  in  the  cur- 
rent assets,  we  have  merchandise  figured  at  cost,  and  receivables 
at  cost  plus.  It  seems  very  evident  that  if  at  any  time  any  manu- 
facturer or  merchant  billed  out  his  entire  inventory,  transforming 
it  into  receivables,  there  would  be  a  considerable  increase  in  the 
total  amount  of  the  current  assets,  which  would  not  make  neces- 


238  BANKING  AND  CREDIT  [  XVII 

sary  any  increase  in  the  current  debt,  as  has  the  cost  of  manufac- 
ture. It  might  be  a  mere  bookkeeping  transaction,  accomplished 
easily  and  injecting  into  the  current  assets  an  amount  equivalent 
at  the  very  least  to  the  entire  expected  profits  on  the  transaction. ' 

The  above  discussion  of  billing  out  the  whole  inventory  to 
make  a  profit  seems  over  technical.  If  it  be  legitimate,  well  and 
good ;  no  harm  has  been  done.  If  it  were  done  to  deceive,  it  would 
be  a  fraudulent  transaction.  Careful  outside  investigation  of  the 
borrower's  character  would  show,  no  doubt,  that  the  moral  risk 
was  not  first  class. 

The  proper  basis  of  an  inventory  appraisal  is  largely  a  matter 
of  opinion,  but  whatever  method  is  followed  should  be  clearly 
indicated  somewhere  in  the  credit  statement  or  the  accompanying 
data.  Particularly  in  a  period  of  falling  commodity  prices  a 
statement  should  indicate  whether  cost  or  present  values  were 
used  in  figuring  the  inventory  and  also  the  depreciation  that  has 
taken  place  from  the  time  the  statement  was  made. 

In  the  business  depression  of  1920  and  192 1  many  concerns 
got  into  financial  difiiculties  largely  on  account  of  unusual  shrink- 
age in  inventory  values  and  greatly  diminished  sales  coupled  with 
heavy  debts.  However,  even  in  times  of  active  business  the 
merchandise  account  is  very  often  a  comparatively  slow  asset, 
particularly  in  the  case  of  a  manufacturing  concern.  The  raw 
material  must  be  put  through  the  various  factory  operations,  the 
finished  goods  must  be  sold,  and  finally  30  or  60  days'  credit  must 
be  extended  before  cash  is  collected. 

Since  it  is  not  feasible  in  most  audited  statements  for  the  ac- 
countants to  supervise  personally  the  taking  of  the  inventory  or 
to  make  an  independent  appraisal,  much  reliance  must  be  placed 
on  the  integrity  of  the  borrower  to  furnish  an  honest  inventory. 
Besides  the  matters  mentioned,  however,  there  are  a  number  of 
other  points  to  be  observed  in  examining  the  merchandise  ac- 


'  Alexander  Wall,  "Study  of  Credit  Barometrics, "  Federal  Reserve  Bulletin,  March  i. 
1919,  pp.  229-243- 


XVII  ]  ITEMS  OF  A  CREDIT  STATEMENT  239 

count  and  they  may  be  stated  as  given  below.  In  most  of  these 
cases,  to  be  sure,  the  person  who  is  analyzing  a  credit  statement 
must  place  reliance  on  the  accuracy  of  the  public  accountant  who 
has  made  the  audit,  or  else  on  the  integrity  of  the  company  itself. 
I .  In  a  business  where  the  average  gross  profit  remains  fairly 
constant  it  is  possible  to  obtain  a  dependable  check  upon  the 
inventory,  provided  the  inventory  figure  for  the  beginning  of  the 
fiscal  period  is  correct.  The  so-called  ''gross-profit "  test  consists 
of  adding  to  the  previous  inventory  the  purchases  and  deducting 
the  sales  at  cost.  The  percentage  of  gross  profit  is  also  compared 
with  that  of  previous  years  and  in  the  case  of  a  business  which 
operated  on  a  fairly  constant  rate  of  gross  profit,  any  discrepancy 
will  usually  be  due  to  errors  in  stock-taking.  Suppose,  for  in- 
stance, that  the  net  sales  of  a  company  amounted  in  1920  to 
$640,000  and  the  cost  price  of  the  goods  sold  was  $520,000.  The 
gross  profit  would  be  $120,000,  or  18.8  per  cent.^  Also  let  us  as- 
sume that  after  the  closing  of  the  books  in  192 1  the  following  data 
are  shown: 

Net  sales $780,000 

Opening  inventory 1 00, 000 

Purchases  (net) 800,000 

Closing  inventory 300,000 

From  these  figures  we  would  arrive  at  a  gross  profit  of  $180,000 
or  about  23.1  per  cent.-  If  this  increase  in  percentage  of  gross 
profits  of  4.3  per  cent  can  be  explained  by  business  conditions, 
then  probable  accuracy  of  the  inventory  has  been  established  by 
the  test.  But  had  there  been  reported  a  closing  inventory  of 
$100,000,  a  loss  of  $20,000,  or  2.5  per  cent,  would  result.  The 
change  of  21.3  per  cent  would  suggest  that  something  was  wrong, 
and  if  unexplained  by  the  increased  costs  of  material,  labor,  and 
overhead,  the  conclusion  might  be  drawn  that  the  closing  inven- 
tory figure  was  inaccurate. 

2.  Where  the  basis  of  inventorying  is  the  company's  own 

^  Sales,  and  not  cost,  used  as  basis  of  computing  profit  in  this  instance. 


240  BANKING  AND  CREDIT  [  XVII 

manufacturing  cost,  it  should  be  ascertained  whether  such  cost 
includes  any  overhead  charge  for  interest.  It  is  customary  for 
cost  accountants  to  exclude  interest  from  inventory  figures  even 
if  it  has  been  included  in  factory  overhead.  In  short  it  is  the 
general  policy  to  exclude  interest,  selling  expenses,  and  adminis- 
trative expenses  from  inventory  prices. 

3.  Trade  discounts  should  be  deducted  from  inventory  prices, 
but  it  is  not  customary  to  deduct  cash  discounts. 

4.  When  goods  consigned  to  others  are  included  they  should 
be  valued  on  the  same  basis  as  other  merchandise,  and  proper 
allowance  should  be  made  for  loss,  damage,  or  expenses  of  possible 
subsequent  return. 

5.  In  the  event  of  an  abnormally  large  merchandise  account 
it  is  desirable  to  ascertain  the  reason  in  order  to  be  sure  that  there 
has  been  no  serious  error  in  stock-taking.  Large  quantities  of 
stock  on  hand  may  be  the  result  of  business  foresight  in  buying 
in  a  low  market,  or  lack  of  business  foresight.  In  some  cases  an 
unusually  large  inventory  is  necessary  because  of  the  concern's 
distance  from  its  source  of  supply.  Seasonal  conditions,  such  as 
the  Christmas  holidays,  may  also  affect  the  inventories. 

6.  Import  duties  and  freight  charges  are  considered  proper 
additions  to  the  cost  price  of  goods,  but  no  other  items  should  be 
added  except  under  special  circumstances. 

7.  If  a  company  has  discontinued  during  the  year  the  manu- 
facture or  sale  of  any  of  its  products,  the  inventories  of  such  items 
should  be  carefully  scrutinized. 

8.  It  should  be  ascertained  that  nothing  has  been  included 
that  has  been  sold  and  billed  and  is  simply  awaiting  shipment. 

9.  Sometimes  errors  are  made  in  not  including  under  liabili- 
ties unpaid  invoices  for  merchandise  received  at  or  just  previous 
to  the  time  of  inventorying. 

10.  If  a  company  has  taken  steps  to  increase  the  selling  price 
of  its  goods,  obviously  the  inventory  has  a  higher  potential  value 
than  before. 


XVII 1  ITEMS  OF  A  CREDIT  STATEMENT  24I 

11.  The  inventory  and  gross  sales  may  have  an  important 
connection  and  should  be  compared.  Some  merchants  prefer  to 
accumulate  a  large  stock  of  old  goods  rather  than  to  dispose  of 
them  below  cost.  If  the  turnover  has  been  abnormally  small  it 
may  be  due  to  a  poor  stock  of  goods. 

12.  Particularly  important  is  the  matter  of  insurance  on  mer- 
chandise as  well  as  on  the  plant  and  equipment.  In  this  connec- 
tion it  is  well  to  explain  briefly  the  so-called  "80  per  cent  rule" 
which  is  widely  in  force  in  the  insurance  business  and  which  is  not 
generally  understood.  If  the  insured  does  not  carry  insurance  to 
the  amount  of  80  per  cent  of  the  value  of  the  property,  in  the 
event  of  loss  or  damage  he  can  only  recover  such  proportion  as  the 
amount  of  the  insurance  carried  bears  to  the  80  per  cent  which  he 
should  have  carried  (and  consequently  becomes  a  coinsurer  for 
any  deficiency).  For  example,  if  the  property  is  worth  $10,000 
and  $6,000  insurance  is  carried,  in  case  of  a  loss  of  $3,000  the 
insured  could  recover  only  three-fourths  of  the  loss,  or  $2,250. 
The  reasonableness  of  the  80  per  cent  clause  can  be  illustrated. 
If  one  owner  who  pays  a  premium  on  $6,000  has  a  loss  of  $3,000 
and  recovers  in  full  and  another  pays  a  premium  on  $8,000  and 
suffers  a  similar  loss,  the  burden  has  been  unequal. 

6.  Acceptances  Held. — When  companies  sell  their  merchan- 
dise on  an  acceptance  basis,  the  acceptances  are,  of  course,  avail- 
able for  discount  by  bankers,  or  for  disposal  in  the  open  market. 
This  obviates  to  a  large  extent  the  necessity  of  a  company's  bor- 
rowing on  its  own  note.  The  discount  or  sale  of  such  acceptances, 
unless  "without  recourse,"  constitutes  a  contingent  liability. 
Acceptances,  both  bankers'  and  trade,  are  treated  at  length  in  a 
separate  chapter. 

7.  Current  Liabilities. — The  liabilities  in  which  the  buyer  of 
commercial  paper  is  most  concerned  are:  (i)  notes  payable  (bills 
payable),  (2)  accounts  payable,  (3)  acceptances,  (4)  reserve  for 


242  BANKING  AND  CREDIT  [  XVII 

income  and  excess  profits  taxes,  (5)  other  current  liabilities,  (6) 
bonded  indebtedness  that  will  mature  within  the  year,  and  (7) 
contingent  liabilities. 

8.  Notes  Payable  (Bills  Payable). — Notes  and  bills  payable 
are  used  synonymously  and  include  notes  given  for  purchase  of 
merchandise,  notes  sold  to  banks,  notes  sold  in  the  open  market, 
and  notes  payable  to  stockholders,  directors,  officers,  friends,  and 
relatives.  Often  notes  are  also  given  for  equipment,  are  made 
payable  in  instalments,  and  are  secured  by  a  chattel  lien  on  the 
equipment.  Notes  of  this  character  are  not  a  liability  to  be  in- 
cluded in  the  statement  unhss  the  property  which  they  represent 
is  listed  as  an  asset,  in  which  event  the  two  corresponding  items 
should  be  treated  as  contingent  assets  and  contingent  liabilities. 

What  is  regarded  as  a  sound  credit  principle  in  one  line  of 
business  may  not  apply  at  all  in  another.  The  giving  of  notes  for 
merchandise  is  still  customary  in  some  trades  ■'  and  is  not  regarded 
as  a  sign  of  weakness,  as  in  the  raw  silk  industry,  with  tobacco- 
packers,  with  manufacturers  of  agricultural  implements,  and 
with  jobbers  in  sparsely  populated  sections  of  the  country.  In 
most  lines  of  staple  commodities,  however,  it  is  not  the  practice  to 
issue  notes,  and  their  appearance  is  immediately  a  danger  signal 
indicating  that  the  company  is  short  of  working  capital. 

Generally  speaking,  a  concern  should  not  have  two  forms  of 
paper  outstanding  at  the  same  time.  If  merchandise  purchases 
are  settled  by  note  or  by  acceptances  and  the  concern  negotiates 
a  loan  at  the  bank  on  its  single-name  paper,  a  bad  impression  is 
created  because  the  loan  at  the  bank  implies  cash  payments  for 
the  merchandise.  Similarly,  if  notes  are  sold  on  the  market  for 
the  purpose  of  taking  cash  discounts,  the  persons  from  whom  the 
goods  have  been  purchased  should  not  be  given  notes  or 
acceptances. 

If  the  borrower's  statement  shows  an  odd  amount  for  notes 


^  Meredith  Wood,  "  Credit  Danger  Signals, "  Bankers  Magazine,  June  1920. 


Xni  I  ITEMS  OF  A  CREDIT  STATEMENT  243 

payable  it  is  almost  certain  that  the  item  contains  notes  of  the 
firm  given  for  purchases.  When  single-name  paper  is  submitted 
to  a  bank  for  discount  or  is  sold  in  the  open  market,  it  is  issued  in 
round  amounts  and  therefore  the  presence  of  odd  cents  is  indica- 
tive of  the  existence  of  other  kinds  of  paper.  Sometimes,  however, 
this  odd  amount  is  due  to  the  fact  that  the  company  has  accepted 
deposits  of  money  from  directors,  officers,  friends,  or  relatives  in 
return  for  its  notes  and  has  credited  the  notes  payable  item  with 
the  interest  accumulations.  A  further  explanation  of  this  odd 
amount  might  be  the  practice  of  some  companies  of  deducting  the 
unearned  interest  charge  on  their  discounted  notes.  Still  another 
reason  might  be  the  fact  that  the  firm  has  included  its  commit- 
ments through  the  acceptance  by  its  banks  of  drafts  drawn  under 
commercial  letters  of  credit. 

In  general,  where  a  company  has  borrowed  on  notes  from  its 
stockholders,  directors,  or  officers,  or  from  friends  and  relatives, 
it  is  very  apt  to  experience  internal  friction  and  financial  embar- 
rassment in  the  event  of  trouble.  Sometimes  loans  of  this  char- 
acter are  used  as  the  means  by  which  control  of  management  is 
secured.  Naturally,  if  a  stockholder,  director,  officer,  or  a  friend 
has  made  large  loans  to  a  company  in  return  for  its  promissory 
note,  he  will  be  able  to  exert  considerable  influence  over  the  busi- 
ness and  possibly  by  threatening  to  demand  payment  may  be  able 
to  secure  control  of  affairs.  Unless  it  is  sufficiently  certain  that  a 
company's  indebtedness  of  this  kind  has  been  definitely  subordi- 
nated to  the  general  creditors  and  is  fixed  in  the  business  for  a 
specific  period,  such  an  item  should  not  be  considered  a  slow 
liability. 

Deposit  accounts  with  the  firm  present  a  somewhat  similar 
disadvantage.  If  they  are  large  they  may  prove  a  source  of 
danger  to  creditors  other  than  the  depositors,  unless  withdrawals 
are  restricted.  These  depositors  are  usually  persons  who  have 
associations  with  the  company  and  are  first  to  know  of  its  financial 
troubles  and  to  protect  themselves  by  withdrawing  their  funds. 


244  BANKING  AND  CREDIT  [  XVII 

Another  danger  signal  is  flashed  when  a  concern  is  obliged  to 
settle  for  its  minor  bills  by  giving  its  note.  An  incident  illustrat- 
ing the  ever-alert  credit  sense  of  one  of  our  well-known  American 
bankers  is  pertinent  at  this  point. 

This  banker  had  been  purchasing  at  frequent  intervals  for  his 
institution  the  commercial  paper  of  a  large  and  supposedly  pros- 
perous trade  house,  regarding  it  as  a  prime  banking  investment. 
The  latest  maturity  of  the  company's  note  had  been  properly 
liquidated  several  months  before,  and  the  local  broker  had  offered 
him  a  substantial  amount  of  the  concern's  paper  again,  which  he 
now  held  under  option,  and  was  considering  buying.  Quite  acci- 
dentally he  happened  to  run  across  something  which  many  other 
men  would  have  passed  over  without  very  much  thought,  in 
view  of  thecompany'sgenerally  strong  and  well-established  rep- 
utation: he  found  that  one  of  his  depositors,  who  had  been  sell- 
ing the  concern  in  question  in  small  amounts,  had  received  quite 
unexpectedly  the  company's  note  for  a  small  bill  amounting  to 
two  or  three  hundred  dollars.  The  banker  learned  of  this  and 
immediately  sent  the  paper  back  to  the  broker.  "We  loan  no 
concern  which  has  to  pay  for  its  minor  bills  by  giving  its  note, " 
he  said.  It  was  simply  a  slight  bit  of  warning,  the  single  flash  of 
a  red  flag,  which  his  keen  credit  sense  detected  at  once.  Eight 
months  later  the  company  in  question  closed  its  doors  and  failed."* 

Commercial  paper  should  never  be  issued  for  financing  of 
permanent  or  fixed  assets.  Plant,  machinery,  and  equipment 
should  represent  contributed  capital  and  funds  received  from  the 
issue  of  bonds  and  other  long-term  obligations.  It  is.  not  the 
function  of  a  commercial  bank  to  finance  investments  of  this 
kind.  The  scope  of  its  activities  is  confined  for  very  good  and 
obvious  reasons  to  short-time  loans  of  a  liquid  character. 

When  possible  a  credit  statement  should  classify  the  notes 
payable  so  as  to  indicate  those  which  were  given  directly  to  the 
banks  of  the  company  and  those  which  were  sold  in  the  open 
market.  The  former  are  not  so  much  a  source  of  concern  as  the 
latter,  because  it  is  more  probable  that  they  can  be  renewed  with- 


4  Meredith  Wood,  "Credit  Danger  Signals,"  Bankers  Magazine,  June  1920,  p   833. 


XVII  ]  ITEMS  OF  A  CREDIT  STATEMENT  245 

out  difficulty  in  case  of  necessity.  Their  existence  limits  the 
firm's  borrowing  capacity,  however,  and  places  it  in  a  less  favor- 
able position  to  ask  for  assistance  from  its  bank  if  the  occasion 
arises. 

Inquiry  should  be  made  in  a  study  of  the  notes  payable  item 
to  learn  whether  any  collateral  has  been  pledged  with  them.  If 
collateral  has  been  furnished  with  some  of  the  notes  but  not  with 
others,  a  considerable  source  of  danger  may  exist  for  the  unse- 
cured creditors. 

Notes  payable  may  be  given  directly  for  merchandise  or  they 
may  be  substituted  later  for  accounts  payable.  Notes  of  this 
latter  character  are  apt  to  indicate  that  merchandise  discounts 
have  been  neglected  and  a  large  volume  of  such  notes  given  for 
goods  bought  some  time  previously  expresses  at  once  an 
unhealthy  condition. 

The  term  "renewal"  when  used  in  connection  with  com- 
mercial loans  often  gives  rise  to  erroneous  opinions.  For  the 
purpose  of  financing  current  transactions  it  is  customary  for 
merchants  and  others  to  borrow  funds  from  banks  on  notes! 
When  a  note  matures  it  is  not  unusual  for  a  new  one  to  be  given 
in  its  place  and  this  is  commonly  called  a  "renewal."  However, 
if  the  merchandise  bought  from  the  proceeds  of  the  original  note 
has  been  disposed  of  in  the  trade  of  the  merchant  and  the  new 
note  is  for  the  purpose  of  making  further  purchases,  the  new  note 
is  not  strictly  speaking  a  renewal  but  represents  in  reality  a  new 
loan.  So  long  as  the  bank  is  not  furnishing  funds  for  fixed  capital, 
there  is  no  reason  why  it  should  not  continue  making  these  new 
loans  at  the  expiration  of  the  old  ones.  An  examination  of  the 
borrower's  credit  statement  showing  for  comparative  periods  the 
margin  of  quick  assets,  the  sales  and  purchases  of  merchandise 
will  indicate  the  quality  of  the  note,  which  is  the  real  test. 

9.  Accounts  Payable. — This  term  represents  purchases  on 
open  credit  charged  on  the  books  of  the  sellers  against  the  buyer 


246  BANKING  AND  CREDIT  [  XVII 

and  to  be  settled  on  stated  terms.  Comparatively  speaking,  the 
amount  of  accounts  payable  outstanding  should  never  be  large. 
A  well-managed  concern  will  borrow  money  at  its  bank  in  order 
to  obtain  cash  discounts  for  prompt  settlements.  If  a  man  whose 
credit  is  good  can  borrow  money  at  6  per  cent  per  year,  it  is  poor 
finance  to  borrow  money  at  2  per  cent  for  20  days  or  36  per  cent 
per  year,  as  he  is  doing  when  he  is  offered  2  per  cent  discount  in 
10  days  but  pays  net  in  30  days.  A  large  accounts  payable  item 
is,  therefore,  a  warning  to  the  analyst  that  the  concern  is  probably 
neglecting  its  merchandise  discounts.  Assuming  that  the  terms 
on  which  the  concern  buys  merchandise  are  2  per  cent  discount  if 
settled  in  10  days,  if  the  unpaid  bills  represent  10  days'  purchases 
they  would  not  be  excessive. 

If  a  company  issues  notes  to  its  creditors  or  to  its  bank,  the 
amount  of  accounts  payable  should  be  particularly  small.  In 
some  statements  the  accounts  payable  item  includes  only  ac- 
counts in  process  of  audit,  often  barely  a  day's  purchases,  which 
is  an  excellent  sign  of  good  management. 

If  the  statement  has  not  been  audited  by  public  accountants, 
care  should  be  taken  to  learn  whether  debts  for  all  goods  received 
on  the  last  day  of  the  fiscal  period,  and  also  for  any  merchandise 
that  was  in  transit  and  belonged  to  the  concern  on  that  date,  are' 
included  as  liabilities,  and  the  corresponding  assets  included  in  the 
inventories.  Concerns  often  hold  up  entries  at  the  endx)f  the  year 
and  do  not  include  considerable  amounts  of  merchandise  in 
transit.  Apropos  of  this  point  a  credit  man  with  a  well-known 
mercantile  agency  tells  of  a  company  whose  audited  statement 
showed  an  increase  in  merchandise  from  $300,000  to  $400,000 
with  a  similar  increase  in  debts  and  largely  for  this  reason  was 
refused  a  loan  at  its  bank. 

10.  Acceptances  Given. — This  item  includes  trade  and  bank 

acceptances.  For  the  purpose  of  making  the  statement  as  explicit 
as  possible  acceptances  should  be  shown  separately  from  notes 


XVII  ]  ITEMS  OF  A  CREDIT  STATEMENT  247 

and  bills  payable.  As  already  stated  in  the  section  dealing  with 
notes  payable,  a  concern  should  not  issue  acceptances  and  another 
form  of  paper  at  the  same  time.  While  the  use  of  acceptances  is 
as  yet  decidedly  limited,  it  is  anticipated  that  as  business  men 
become  more  accustomed  to  this  kind  of  paper  it  will  be  more 
generally  used.  A  more  complete  discussion  of  acceptances  is 
presented  in  a  separate  chapter. 

II.  Reserves. — The  term  "reserve"  in  a  financial  statement 
is  used  commonly  in  three  different  senses.  It  may  indicate  an 
offset  or  valuation  account  as  reserve  for  depreciation ;  it  may  be 
of  the  nature  of  surplus,  as  sinking  fund  reserve  or  reserve  for 
additions  and  betterments;  or  it  may  represent  accrued  liabilities 
as  taxes  and  wages.  Reserves  for  depreciation  usually  represent 
the  estimated  depreciation  of  one  or  more  of  the  fixed  assets  from 
which  they  must  be  deducted  to  determine  their  real  book  value. 
Reserves  for  bad  or  doubtful  accounts  are  another  important 
class  of  valuation  reserves  and  must  be  offset  against  accounts 
receivable  to  obtain  the  estimated  value  of  the  latter.  There  is 
a  tendency  at  present  to  list  valuation  reserves  on  the  resource 
side  of  the  balance  sheet  where  they  are  shown  as  subtractions 
from  the  corresponding  assets.  As  a  further  step  in  simplifying 
the  balance  sheet  terminology  and  technique,  many  statements 
use  the  term  "allowance"  instead  of  reserve. 

Reserves  of  the  nature  of  surplus  are  less  common  than  the 
other  kinds  of  reserve,  and  when  they  occur  they  usually  can  be 
recognized.  They  can  be  considered  simply  as  surplus  items  for 
special  purposes,  and  do  not  come  under  current  assets  or 
liabiHties. 

Until  the  government  has  materially  reduced  the  income  and 
corporation  taxes,  the  statement  of  every  borrower  should  show 
a  provision  for  this  liability.  As  the  tax  is  specifically  based 
upon  the  net  profits  of  a  particular  period,  although  payable 
some  months  thereafter,  the  tax  accrues  throughout  the  specified 


248  BANKING  AND  CREDIT  XVII 

period  and  should  be  properly  indicated  on  the  balance  sheet. 
Very  often  this  reserve  will  amount  to  hundreds  of  thousands  of 
dollars,  and  since  it  is  a  quick  liability  that  will  have  to  be  paid 
within  a  comparatively  short  period  of  time,  it  is  essential  that  it 
be  carried  on  the  statement.  If  a  concern  has  a  large  federal  tax 
bill  to  meet  and  fails  to  give  some  evidence  on  its  statement  of 
the  impending  obligation,  it  is  probably  because  the  statement 
indicates  a  rather  weak  current  ratio. 

One  writer  describes  the  statement  of  a  house  offering  its 
paper  in  the  open  market  which  appeared  to  show  obviously  this 
condition  of  afTairs.  Its  current  ratio  for  19 18  had  been  much 
more  favorable  than  for  19 19,  a  substantial  reserve  amounting  to 
about  $300,000  having  been  carried  in  the  19 18  figures.  As  no 
reserve  at  all  appeared  on  the  19 19  statement  it  was  natural  to 
assume  that  the  concern  had  decided  that  by  simply  omitting  this 
item  altogether  its  absence  would  perhaps  be  overlooked  and  the 
ratio  would  benefit  accordingly.  But  a  concern  which  finds  it 
expedient  to  practice  such  a  method  should  realize  that  this  very 
fact  of  attempted  concealment  will  often  injure  it  much  more 
than  telling  the  plain  truth. 

12.  Other  Current  Liabilities. — Ordinarily  the  current  lia- 
bilities that  have  just  been  described  include  all  the  important 
ones  from  the  point  of  view  of  the  bank  analyst.  Most  balance 
sheets  include  other  minor  items  in  addition  to  those  given  and 
in  some  cases  it  may  be  desirable  to  examine  them  in  detail.  The 
more  important  of  these  remaining  items  include:  accrued  lia- 
bilities on  account  of  interest,  wages,  traveling  expenses  and 
commissions,  legal  expenses,  and  incidental  operating  charges. 
However,  it  is  not  within  the  province  of  this  book  to  take  up 
individually  each  of  these  accounting  details,  and  moreover  a 
satisfactory  treatment  of  them  will  be  found  in  almost  any 
standard  book  on  accounting,  to  which  the  reader  is  referred  for 
detailed  information. 


XVII 1  ITEMS  OF  A  CREDIT  STATEMENT  249 

13.  Bonded  Indebtedness  that  Will  Mature  within  the  Year. 

— Ordinarily  the  bank  analyst  is  not  interested  in  the  outstanding 
bonds  and  other  long-term  obligations  of  a  company.  When, 
however,  such  obhgations  are  to  mature  within  the  current  year 
they  become  of  the  same  general  character  as  an  ordinary  current 
liability.  It  is  entirely  possible  that  the  statement  of  a  concern 
will  show  a  not  unsatisfactory  risk  from  the  point  of  view  of  the 
bank,  even  if  the  relation  between  its  total  assets  and  total  lia- 
bilities is  such  that  the  net  worth  is  practically  zero.  If  the  bulk 
of  the  liabilities  are  represented  by  bonds  that  do  not  mature  for 
a  period  of  years,  their  existence  will  be  no  great  source  of  dan- 
ger to  creditors  holding  short-term  notes  and  other  obligations 
maturing  in  the  meantime.  Of  course  if  the  concern's  financial 
standing  is  such  that  the  interest  obligations  on  bonds  cannot  be 
met,  the  situation  of  the  general  creditors  will  be  entirely  different. 
Merchandise  is  not  infrequently  sold  by  concerns  to  customers 
whose  financial  standing  indicates  a  larger  amount  of  bonds  out- 
standing than  justified  by  present  assets  but  which  do  not  ma- 
ture within  the  period  of  payment  specified  in  the  sale.  To  be 
sure,  there  is  a  considerable  amount  of  risk  in  deahng  with  con- 
cerns of  this  character  for  the  reason  that  other  symptoms  are 
quite  likely  to  appear  on  closer  examination. 

14.  Contingent  Liabilities. — The  most  common  form  of  con- 
tingent liabilities  is  that  brought  about  through  the  practice  of 
indorsing  and  discounting  notes  receivable  and  acceptances, 
which  feature  has  already  been  discussed  in  the  section  dealing 
with  notes  receivable.  Other  forms  of  contingent  liabilities  may  be 
found  in  connection  with  the  indorsement  of  outside  paper,  and 
the  financing  of  subsidiary  companies.  Arrangements  with  sub- 
sidiary companies  often  involve  indorsement  of  current  borrow- 
ings, guaranty  of  merchandise  obligations,  and  the  guaranty  of 
their  funded  debts.  A  contingent  liability  sometimes  arises  out 
of  leases  and  contracts  and  other  activities  peculiar  to  some  lines 


250  BANKING  AND  CREDIT  [XVII 

of  business,  the  existence  of  which  may  be  recognized  when  met. 
Contracts  to  accept  the  dehvery  of  goods  forwarded  before  the 
date  of  the  credit  statement  may  call  for  the  payment  of  large 
sums  of  money  within  a  short  time.  In  the  case  of  raw  materials 
for  a  manufacturer  this  might  be  a  perfectly  good  reason  for  seek- 
ing a  temporary  loan  pending  production  and  sale,  but  for  a 
merchant  whose  statement  shows  a  large  stock  of  goods  on  hand 
it  might  indicate  a  real  liability  impending  with  assets  of  a  doubt- 
ful character  to  offset  it.  A  properly  prepared  audited  statement 
would  indicate  whether  such  purchase  orders  stood  for  stock  in 
excess  of  the  current  and  reasonable  prospective  demand.  Where 
the  contingent  liabihty  has  been  brought  about  through  the  fi- 
nancing of  subsidiary  companies,  it  may  be  necessary  to  inquire 
into  the  financial  conditions  of  the  latter  organizations.  It  is  not 
unusual  for  a  subsidiary  company  to  prove  to  be  a  burden  instead 
of  a  source  of  profit  for  the  parent  organization. 

15.  Capital  Assets  and  Capital  Liabilities. — Although  the 
ability  of  a  company  to  show  on  its  statements  a  substantial 
excess  of  current  assets  over  current  liabilities  is  the  most  essen- 
tial thing  for  the  purpose  of  the  bank  analyst,  nevertheless  it 
must  be  borne  in  mind  that  concerning  any  set  of  figures  it  is 
necessary  to  view  them  as  a  whole  rather  than  to  compare  only 
one  or  two  groups  and  to  rest  the  entire  decision  on  the  results  of 
the  showing  made  by  these  few.  By  confining  the  analysis  to 
only  one  phase  of  credit  some  very  important  danger  signals 
may  be  completely  overlooked. 

One  point  of  special  significance,  particularly  since  the  war, 
is  the  relative  size  of  the  company's  plants  compared  to  its  net 
worth.  During  the  war  the  enormous  increases  in  volume  of 
business  stimulated  plants  to  increase  their  size  rapidly  in  order 
to  keep  up  with  the  large  amount  of  orders  which  they  received. 
Rising  prices,  continued  demand,  and  expectation  of  increasingly 
large  profits  spurred  many  concerns  to  invest  all  their  available 


XVII  ]  ITEMS  OF  A  CREDIT  STATEMENT  251 

liquid  capital  in  additional  expenditures  for  plant  and  equipment. 
Naturally  a  cessation  in  demand  and  a  falling  off  in  prices  left 
the  companies  in  question  with  the  greater  portion  of  their  assets 
completely  tied  up  in  machinery  and  buildings,  and  with  a  com- 
paratively small  net  working  capital.  While  an  addition  to  a  plant 
may  outwardly  be  a  sign  of  prosperity  and  an  increased  volume 
of  business,  the  real  situation  may  be  quite  the  opposite.  Instead 
of  large  orders  and  growing  sales  there  may  take  place  a  gradual 
deflation  of  an  already  unwarranted  demand,  with  the  result 
that  the  concern  is  left  stranded,  overextended  in  capital  assets, 
and  lacking  the  requisite  amount  of  required  funds  to  carry  it 
along. 

In  some  lines  of  trade,  as  in  cotton  mills,  fixed  assets  have  a 
greater  liquidating  value  than  is  the  case  in  many  other  manufac- 
turing industries.  The  machinery  and  equipment  in  a  cotton  mill 
are  for  the  most  part  standardized.  Moreover,  a  large  part  of  it 
can  be  moved  without  great  difhculty.  Second-hand  machinery 
is  frequently  purchased  and  moved  from  one  mill  to  another. 
These  things  tend  to  cause  the  fixed  assets  to  have  a  greater  po- 
tential power  of  liquidation.  However,  it  must  be  remembered 
that  a  bank  always  wishes,  if  possible,  to  avoid  the  necessity  of 
attaching  property  or  forcing  the  sale  of  it  in  order  to  insure  a 
claim.  Measures  of  this  kind  are  a  last  resort;  hence  in  looking 
upon  the  borrowing  company  as  a  self-liquidating  account  the 
bank  analyst  can  consider  only  the  quick  assets  in  the  shape  of 
cash,  bills  receivable,  accounts  receivable,  merchandise,  etc.,  of 
primary  significance. 

16.  Income  Sheet  (Profit  and  Loss  Account,  Revenues  and 
Expenses,  etc.). — A  bank  will  frequently  find  it  possible  to  judge 
a  concern's  standing  much  more  accurately  by  consideration  of  its 
sales  and  expenses  of  doing  business  in  connection  with  its  state- 
ment of  assets  and  liabilities.  In  the  case  of  a  partnership  the 
income  sheet  or  profit  and  loss  statement  will  often  reveal  the 


252  BANKING  AND  CREDIT  ( XVII 

fact  that  the  members  of  the  firm  are  making  too  heavy  with- 
drawals for  personal  expenses.  The  income  sheet  shows  whether 
or  not  the  firm  is  keeping  track  of  the  cost  of  running  the  business 
and  also  whether  or  not  it  is  making  a  profit.  Not  infrequently 
a  credit  risk  is  rated  primarily  upon  whether  the  prospective 
borrower  is  going  ahead  with  a  profit  or  falling  backward  with  a 
loss. 

It  is  the  conventional  practice  for  the  income  sheet  to  start 
with  the  item,  sales.  Sales  includes  all  merchandise  (that  is,  what- 
ever goods  the  firm  is  manufacturing  or  marketing,  and  does  not 
include  sales  of  its  fixed  assets  or  investments),  whether  cash,  on 
open  account,  or  for  notes  or  acceptances  during  the  fiscal  period 
under  consideration.  Sales  should  only  include  valid  transactions 
which  legally  transfer  to  the  purchaser  the  title  to  the  merchan- 
dise. Goods  shipped  on  consignment  or  on  approval  should  not 
appear  in  the  statement  as  regular  sales,  but,  of  course,  should 
be  properly  included  in  the  inventories.  When  it  is  customary  to 
allow  trade  discounts,  either  the  amount  of  such  discounts  should 
be  excluded  from  sales,  or  there  should  be  provision  for  showing  it 
as  a  deduction  or  an  oftset  under  some  such  caption  as  "trade 
discount  on  sales." 

17.  Importance  of  Sales  Returns. — In  some  lines  of  business 
the  item  of  sales  returns  is  an  important  one.  An  examination  of 
this  account  will  determine  just  what  percentage  of  the  sales  are 
returned  and  whether  this  undesirable  feature  is  increasing  or 
decreasing.  Where  possible  a  statement  should  separate  cash 
sales  from  sales  on  credit.  This  information  is  of  value  when  de- 
termining the  relation  between  the  customers'  unpaid  accounts 
and  the  total  charge  sales  for  the  period.  To  be  more  concrete, 
suppose  the  annual  sales  on  credit  on  open  account  were  $900,000 
and  that  the  average  term  of  credit  granted  is  30  days,  and  that 
the  current  assets  show  $150,000  under  accounts  receivable.  If 
it  were  known  that  the  firm's  monthly  sales  were  fairly  uniform 


XVII  1  ITEMS  OF  A  CREDIT  STATEMENT  253 

and  that  no  extraordinarily  large  sales  had  been  made  recently, 
it  would  be  reasonable  to  infer  that  either  the  firm's  collection 
methods  were  lax,  or  else  that  accounts  receivable  included  some 
bad  and  doubtful  items.  Assuming  that  under  normal  conditions 
there  will  be  an  appreciable  number  of  customers  who  will  dis- 
count their  bills,  a  firm  that  is  selling  goods  on  30  days'  credit 
should  be  able  to  prevent  its  accounts  receivable  from  exceeding 
2  months'  sales. 

18.  Comparison  of  Sales  and  Inventory. — For  the  purpose  of 
testing  the  efficiency  of  the  management  it  is  desirable  to  compare 
the  total  sales  and  the  final  inventory.  In  making  this  compari- 
son, however,  consideration  must  be  given  to  the  nature  of  the 
goods  or  more  particularly  to  the  time  required  to  replenish  stock. 
If  the  total  sales  of  a  manufacturing  concern  amount  to  <S  1,500, - 
000  and  the  final  inventory  shows  a  balance  of  $600,000,  it  would 
seem  fairly  conclusive  that  there  is  too  much  money  tied  up  in 
stock-in-trade.  The  conclusion  would  be  more  certain  if  it  were 
found  that  the  manufacturing  operations  required  on  the  average 
about  3  weeks. 

If  the  gross  profit  on  sales  for  the  fiscal  period  in  question  was 
substantially  the  same  as  for  the  preceding  periods,  the  probability 
of  inventory  inflation  would  not  be  great.  On  the  other  hand,  it  is 
quite  possible  that  the  inventory  includes  some  dead  stock  and 
goods  out  of  style,  or  goods  for  which  there  is  no  profitable 
market.  Moreover,  the  concern  may  have  overestimated  its 
requirements  for  raw  materials  or  may  have  manufactured  more 
heavily  than  subsequent  sales  justified.  Before  arriving  at  final 
conclusions,  however,  it  is  necessary  to  obtain  further  tacts  and 
to  examine  them  in  the  light  of  market  conditions.  During  a 
period  of  rising  prices  and  keen  business  activity  the  purchase  of 
large  quantities  of  raw  materials  to  anticipate  future  needs  may 
prove  to  be  a  prudent  and  highly  profitable  transaction.  But 
when  the  market  begins  to  sag,  the  situation  becomes  reversed 


254  BANKING  AND  CREDIT  |  XVII 

and  companies  which  have  large  stocks  of  merchandise  may  be 
required  to  register  in  their  expense  accounts  millions  of  dollars 
because  of  shrinkage  on  inventory  values. 

References 

Ettinger,  R.  P.,  and  Golieb,  D.  E.     Credits  and  Collections. 

Construction  and  analysis  of  the  credit  statement,  pp.  186-250. 
Illustrated  with  blank  forms. 
Westerfield,  R.  B.     Banking  Principles  and  Practice. 

The  work  of  the  credit  department  of  a  bank,  including  sources  of 
information  and  interviews  with  borrowers,  Vol.  IV,  pp.  935-955. 
Nature  of  a  financial  statement  and  the  significance  of  its  main 
items.  Vol.  IV,  pp.  956-968. 
Willis,  H.  P.,  and  Edwards,  G.  W.     Banking  and  Business. 

Principal  items  in  the  borrower's  statement;  sources  of  credit  in- 
formation and  determination  of  line  of  credit,  pp.  11 2-1 22. 

Any  standard  book  on  accounting  deals  with  the  items  of  a  balance 
sheet  and  profit  and  loss  statement.    See  especiall)': 

Cole,  W.  M.     Accounts,  Their  Construction  and  Interpretation. 

Interpretation  of  balance  sheets,  pp.  104-109. 
Hatfield,  H.  R.     Modern  Accounting,     pp.  35-69. 

Paton,  W.  A.,  and  Stevenson,  R.  A.     Principles  of  Accounting,     pp.  545- 
598. 

Note:     See  Appendix  A,  Problem  20. 


CHAPTER  XVIII 
ANALYSIS   OF   TYPICAL   CREDIT   STATEMENTS 

In  this  chapter  a  number  of  typical  credit  statements  are 
given,  with  an  analysis  of  each.  The  first,  that  of  the  Cotton 
Mill  Corporation,  is  dated  September  i,  19 — ,  and  is  as  follows: 

Cotton  Mill  Corporation 
September  i,  19 — 

A  ssets 

Current: 

Cash $118,364.43 

Accounts  receivable 50,1 15.38 

Notes  receivable i  ,663.2 1 

Inventories: 

Cotton 121,667.70 

Finished  goods 123,525.64 

Stock  in  process,  supplies  and  waste 216,747.59        $632,083.95 

Fixed  Assets : 

Real  estate $50,465.37 

Buildings  and  fixtures 637,076.71 

Machinery 830,501.12 

$1,518,043.20 

Less:  Reserve  for  depreciation 405,142.21        1,112,900.99 

Total  assets $1,744,984.94 

Liabililies 

Current: 

Accounts  payable $238,096.48 

Notes  payable 630,695.30 

Accrued: 

Labor 13,213.80 

Taxes — domestic 6,934.92 

Employees'  deposits  and  uncalled-for  wages  4,266.03        $893,206.53 

Reserve  for  federal  taxes 21,500.00 

Capital  stock $1,000,000.00 

Less:  Impairment 169,721.59  830,278.41 

Total  liabiHties $1,744,984.94 

vSales I305, 160.00 

Net  loss 15,650.00 

255 


256  BANKING  AND  CREDIT  [  XVIII 

This  statement  indicates  such  a  poor  financial  condition  that 
the  concern  could  hardly  expect  to  obtain  a  bank  loan.  Current 
assets  are  less  than  current  liabilities,  and  in  order  to  show  a 
current  ratio  of  2  to  i  it  would  be  necessary  to  treble  current 
assets.  It  seems  evident  that  collections  are  slow,  since  the  re- 
ceivables represent  an  amount  in  excess  of  2  months'  average 
sales.  Notes  payable  alone  are  almost  equal  to  total  current 
assets,  and  the  latter  includes  raw  material  and  stock  in  process, 
which  probably  cannot  be  liquidated  before  thematurity  of  the 
notes.  Not  only  has  the  surplus  account  disappeared  but  there 
is  an  impairment  of  the  capital  investment;  that  is,  the  equity  of 
the  stockholders  in  the  business  is  less  than  the  face  value  of  the 
capital  stock.  Finally,  during  the  year  the  company  did  not 
earn  enough  to  pay  operating  expenses  and  suffered  a  loss  of 
$15,650.  It  would  appear  from  all  these  facts  that  bankruptcy 
cannot  be  far  off  unless  the  stockholders  contribute  more  working 
capital  or  provision  is  made  for  funding  some  of  the  current 
debts. 

First  INIetal  Products  Company 
Comparative  Balance  Sheets  on  December  31,  iqiq,  1020,  1921 

A ssets 

1919  1920  1921 
Capital  assets: 

Land  and  buildings $75,000.00  $75,000.00  $75,000.00 

Machinery  and  equipment .. .         23,849.14  24,139.85  25,412.26 

Furniture  and  fixtures 5,624.36  5.879-63  6,283.22 

Good-will 40,000.00  40,000.00  40,000.00 

Total $144,473.50         $145,019.48         $146,695.48 

Working  and  trading  assets: 

Materials  and  supplies $27,349.23  $28,172.40  $17,275.19 

Finished  goods 15,763.88  22,587.15  32,260.55 

Total $43,113.11  $50,759-55  I49.535-74 


XVIII 1     ANALYSIS  OF  TYPICAL  CREDIT  STATEMENTS  257 

A sscts 

1919  1920  1921 

Current  assets: 

Cash $18,429.60  $10,010.18  $5,073.49 

Notes  receivable 9,323.22  8,275.31  8,052.50 

Accounts  receivable 20,641.73  27,153.71  23,910.13 

Total $48,394.55  $45,439.20  $37,036.12 

Prepaid  expenses: 

Insurance $800.00  $1,200.00  $1,500.00 

Advertising 1,300.00  2,100.00 

Total $800.00  $2,500.00  $3,600.00 

Total  assets $236,781.16  $243,718.23  $236,867.34 


Liabilities 

1919  1920  1921 

Capital  liabilities; 

Capital  stock  outstanding ..  .  $125,000.00         $125,000.00         $125,000.00 
Mortgage  on  land  and  build- 
ings    40,000.00             40,000.00             40,000.00 

Total $165,000.00         $165,000.00         $165,000.00 

Current  liabilities: 

Accounts  payable $8,015.72          $14,059.87           $19,399-77 

Notes  payable 5,000.00            15,000.00            17,000.00 

Accruals 3,264.20              4,173.24              2,431.50 

Total $16,279.92           $33,233.11           $38,831.27 

Reserv^es : 

Depreciation  of  buildings ...  .  $10,451.75           $12,701.75           $14,951.75 
Depreciation     of     machinery 

and  equipment 6,204.79               7,806.34               9,293.72 

Depreciation  of  furniture  and 

fixtures 1,160.66               1,748.62               2,241.35 

Total $17,817.20          $22,256.71           $26,486.82 

Profit  and  loss  surplus $37,684.04           $23,228.41             $6,549.25 

Total     capital,     liabilities, 

reserves,  and  surplus ... .  $236,781.16         $243,718.23         $236,867.34 


Net  sales $143,259.04  $115,047.31  $108,955.49 

Net  profits 31.925-75  io,544-37  8,320.84 

Dividends 25,000.00  25,000.00  25,000.00 

17 


258  BANKING  AND  CREDIT  I XVIII 

The  comparative  financial  statement  of  the  First  Metal 
Products  Company  indicates  that  the  company  is  in  a  very  un- 
satisfactory condition,  if  not  one  of  practical  insolvency.  The 
current  ratio  has  decreased  materially  in  the  last  three  years,  and 
on  December  30, 192 1 ,  the  current  assets  are  less  than  the  current 
liabilities.  However,  in  all  justice  to  the  company  it  should  be 
noted  that  inventories  of  materials  and  finished  goods  are  not 
carried  under  current  assets,  as  is  the  common  practice.  If  such 
were  done  the  current  ratio  might  seem  at  first  sight  satisfactory, 
but  further  examination  is  necessary  to  throw  light  on  the  char- 
acter and  quality  of  the  quick  assets.  The  cash  balance  in  1921 
is  much  too  small  for  the  needs  of  the  business.  The  ratio  of 
receivables  to  sales  has  increased  so  rapidly  that  in  192 1  there 
are  between  3  and  4  months'  average  sales  not  collected.  This 
not  only  implies  poorer  collection  methods  but  also  arouses  the 
suspicion  that  many  of  the  accounts  are  bad  or  doubtful.  It 
would  appear  from  the  heavy  inventory  of  finished  goods,  which 
doubled  from  1919  to  1921,  while  sales  decreased,  that  greater 
difficulty  is  being  experienced  in  marketing  them  and  that  the 
company  is  unwisely  tying  up  large  amounts  of  capital  in  slow- 
moving  merchandise. 

Finally  at  a  time  when  the  company  is  in  serious  need  of  cash 
there  has  been  maintained  a  high  dividend  rate.  In  order  to  de- 
clare this  dividend  it  has  been  necessary  to  draw  upon  the  surplus 
created  in  former  years  and  diminish  it  to  almost  one-sixth  of  its 
amount  in  1919. 

Colonial  Underwear  Manufacturers 
November  30,  19 — 

Assets  Liabilities 

Cash $308,165.16  Bills  payable  to  banks        ^685,000.00 

Bills  receivable 12,500.00  Bills   payable   to   in- 

Accounts  receivable . .  463,705.03           dividuals 10,500.00 

Stock  on  hand  and  in  Accounts  payable  for 

process 566,816.96          mdse 57,246.57 


XVIII  ]      ANALYSIS  OF  TYPICAL  CREDIT  STATEMENTS 


259 


Investments  in  affili- 
ated companies .... 

Real  estate 

Machinery  and 
fixtures 


99,300.00 
650,019.64 

809,787.01 


$2,910,293.80 


Accounts  payable  to 
individuals 

Reserv'e  for  dividends 

Reserve  for  taxes .... 

Reserve  for  deprecia- 
tion   

Capital  stock 

vSurplus 


60,983.57 
42,000.00 
46,646.22 

733,499-85 
600,000.00 

674.417-59 

$2,910,293.80 


Sales 

Net  profits 

Dividends 

Allowance  for  depreciation . 
No  contingent  liabilities. 


,520,492.00 

121,194.00 

51,000.00 

70,194.00 


This  statement,  while  showing  a  fair  margin  of  current  assets 
to  protect  creditors,  indicates  that  the  business  is  being  operated 
to  a  considerable  degree  on  the  temporary  investment  of  the 
creditors.  For  example,  the  item,  bills  payable,  is  greater  than 
capital  stock  and  is  more  than  one-half  as  large  as  capital  stock 
and  surplus  combined.  The  current  ratio  is  i  1/2  to  i,  or  some- 
what less  than  a  2  to  i  condition  which  bankers  expect  a  good 
statement  to  reveal.  The  merchandise  condition  is  favorable, 
there  being  only  slightly  over  one  month's  goods  on  hand,  al- 
though it  is  apparent  the  concern  is  doing  too  much  business  for 
the  capital  employed. 

The  item,  investments  in  affiliated  companies,  represents 
controlling  interests  in  several  firms,  and  it  would  be  advis- 
able to  request  a  consolidated  statement  so  that  an  analysis 
of  the  whole  might  be  made.  The  profits  show  a  satisfactory 
earning  ability  but  it  would  seem  to  be  a  good  policy  to  accumu- 
late the  profits  instead  of  paying  out  large  dividends.  It  would 
also  be  advisable  to  capitalize  part  of  the  surplus  and  reserve  funds 
which  are  too  large  for  the  capital  now  invested.  Collections 
apparently  are  satisfactory,  as  receivables  show  outstanding  ac- 
counts representing  not  more  than  i  or  2  months'  average  sales. 


260  BANKING  AND  CREDIT  [XVIII 

Statement  for  information  of  banks  and  other  clients  of  R.  P. 

Ross  &  Co.,  who  may  be  interested  in  buying  the  four  months' 

notes  of  the  Stanley  Manufacturing  Company 

R.  P.  ROSS  Sc  CO.    Note-Brokers 

1 8  Tenth  Avenue 
Boston,  Mass. 

14  Exchange  Place 
Members  New  York  and  New  York  City 

Boston  Stock  Exchanges  220  South  LaSalle  St. 

Chicago 

The  facts  and  information  herein,  although  not  guaranteed  by  us, 
have  been  obtained  from  sources  which  we  believe  to  be  reliable  and 
are  given  without  any  responsibility  on  our  part. 

Confidential 

Stanley  Manufacturing  Company 
Boston,  Mass.  December  31,  1921 

A  ssets 

Cash $1,498,359.63 

Accounts  and  notes  receivable 2,270,938.02 

Merchandise  and  material  on  hand 6,941,108.12 

Company's  stock  held  for  sale  to  employees 34,129.86 

Supplies,  prepaid  interest,  and  insurance 150,582.87 

$10,895,118.50 
Plants,  water  powers,  warehouses  and  lands 10,495,728.83 

$21,390,847.33 

Liabilities 

Capital  stock,  common $8,000,000.00 

Capital  stock,  preferred 4,000,000.00 

All  debts 1,221,478.32 

Reserve  for  United  States  income  tax  payable  following  year  750,000.00 

Reserve  for  inventory  depreciation 1,200,000.00 

Surplus  funds 6,219,369.01 

$21,390,847.33 


(Signed)  Stanley  Manufacturing  Company 
By  Charles  A.  Russell,  Treasurer 


XVIII 1     ANALYSIS  OF  TYPICAL  CREDIT  STATEMENTS  26 1 

Springfield,    Mass.     February    9,     1922.     Incorporated    in    Massachusetts. 

Manufacture  twine,  bagging,  etc. 

Plants  at  Springfield,  Mass.;  Boston,  Mass.;  and  Savannah,  Ga. 

During  year  ended  December  31,  1921,  spent  $1,878,784  on  addition  to  plant. 
Charged  to  depreciation  $512,486. 

Sales  $21,000,000. 

Bank  with: 

National  Shawmut  Bank  Boston 

Bank  of  America  New  York 

National  Bank  of  Commerce  Springfield 

Merchants  National  Bank  Springfield 

State  National  Bank  Springfield 

Savannah  Union  Bank  Savannah 

The  foregoing  statement  of  the  Stanley  Manufacturing  Com- 
pany, which  has  recently  sold  to  its  note-brokers,  R.  P.  Ross 
and  Company,  $4,000,000  of  4  months'  notes  bearing  6  per  cent 
interest,  indicates  that  this  firm  is  in  an  excellent  financial  posi- 
tion and  reveals  a  source  of  strength  which  commends  the  paper 
to  prospective  buyers  as  being  of  the  highest  grade.  The  partic- 
ular points  of  merit  in  this  company's  paper  are  as  follows: 

1 .  The  ratio  of  current  assets  to  current  liabilities  is  approxi- 
mately 10  to  I. 

2.  The  cash  account  is  ample  and  is  more  than  sufficient  to 
meet  any  immediate  obligations. 

3.  R.  P.  Ross  and  Company  state  that  the  company  is  a 
seasonal  borrower  and  sells  its  notes  once  a  year  for  the  purpose  of 
financing  the  purchase  of  raw  materials.  When  the  finished 
goods  have  been  sold  and  the  proceeds  received  the  notes  are 
liquidated.  This  fact  makes  its  paper  more  desirable  than  the 
offerings  of  a  company  which  has  some  paper  outstanding  at  all 
times. 

4.  The  ratio  of  accounts  and  notes  receivable  to  sales  is  small, 
indicating  that  the  company's  collection  methods  are  satisfactory. 

5.  The  ratio  of  merchandise  and  material  on  hand  to  sales 
would  not  seem  to  indicate  an  excessive  inventory.  Allowing 
for  the  profit  there  is  about  a  3  months'  supply  of  goods  on  hand. 


262  BANKING  AND  CREDIT  [  XVIII 

6.  Reference  to  statements  for  previous  years  also  shows 
good  credit  conditions. 

7.  Most  important  of  all  is  the  moral  risk.  Trade  references, 
which  have  been  investigated  by  R.  P.  R.oss  and  Company,  and 
the  company's  past  record,  give  evidence  of  the  high  character 
and  integrity  of  its  personnel. 

References 

Kniffin,  W.  H.     Commercial  Paper. 

Analyzes  in  detail  3  5  typical  credit  statements,  pp.  90-1 59. 

Note:     See  Appendix  A,  Problems  21-24. 


CHAPTER   XIX 

SECURITY  AND   OTHER   INVESTMENTS  OF 
COMMERCIAL   BANKS 

1.  Security  Holdings  of  Banks. — In  addition  to  making 
short-term  loans  and  discounts  many  commercial  banks  invest 
in  securities,  generally  bonds.  These  may  be  regarded  as  long- 
time loans ;  but  as  their  date  of  maturity  is  distant  their  liquida- 
tion into  cash  is  not  contemplated  unless  the  bank  is  in  urgent 
need  of  funds.  Their  current  value  is  also  subject  to  fluctuations, 
depending  upon  stock  market  operations,  possible  changes  in 
the  market  rate  of  interest,  and  more  than  all  upon  the  fortunes 
of  the  companies  whose  securities  are  bought.  Funds  so  in- 
vested are  withdrawn  from  immediate  mercantile  and  manu- 
facturing needs  in  the  marketing  of  goods,  and  throught  he  securi- 
ties are  directed  to  construction  or  development  of  plant,  as 
in  the  construction  of  railroads,  pubhc  utilities,  municipal  enter- 
prises, factories,  etc.,  or  to  the  financial  needs  of  governmental 
bodies.  This  business  is  more  generally  undertaken  by  bond 
houses,  sometimes  designated  as  investment  bankers  (whose 
function  is  to  distribute  securities  to  investors)  as  distinguished 
from  commercial  bankers.  Although  this  distinction  is  recog- 
nized, commercial  banks  at  times  find  it  advantageous  to  invest 
a  part  of  their  funds  in  long-time  securities.  Particularly  is  this 
the  case  when  there  is  a  slackening  in  the  demand  for  short-term 
loans.  Rather  than  hold  funds  idle,  the  banks  purchase  bonds 
which  will  yield  an  income. 

2.  Classes  of  Securities. — Securities  generally  appear  in  the 
balance  sheet  of  a  national  bank  under  four  headings : 

263 


264  BANKING  AND  CREDIT  [XIX 

1.  United  States  government  securities,  including  the  older 

issues  of  bonds,  Liberty  bonds.  Victory  notes,  United 
States  certificates  of  indebtedness. 

2.  Stock  of  federal  reserve  bank. 

3.  Other  bonds,  securities,  etc.  (other  than  stocks). 

4.  Stocks  other  than  federal  reserve  bank  stock. 

Investments  in  securities  by  national  banks  in  1920  (June 
30)  are  shown  in  the  following  table.  Figures  for  loans  and  total 
resources  are  also  given  for  purposes  of  comparison : 

Millions 

United  States  government  securities  owned $2,269.6 

Stock  of  federal  reserve  banks 65.3 

Other  bonds,  securities,  etc 1,802.2 

Stocks  other  than  federal  reserve  bank  stock 49.4 

Total  securities $4, 186.5 

Loans  and  discounts.  .  .  : 12,396.9 

Total  resources 22, 196.7 

The  securities  may  be  further  classified:' 

Millions 

United  States  bonds  other  than  Liberty  bonds $815.4 

Liberty  loan  bonds  and  Victory  notes i  ,454.  i 

Total  United  States  obligations $2,269.5 

State,  county  or  other  municipal  bonds 338.4 

Railroad  bonds 416.4 

Other  public  service  corporation  bonds 283.1 

All  other  bonds  (domestic) 309.8 

Claims,  warrants,  judgments,  etc 67.7 

Collateral  trust  and  other  corporation  notes  issued  for  i  to  3  years  145-9 

Foreign  government  bonds 180.0 

Other  foreign  bonds  and  securities 61.0 

Stocks,  federal  reserve  banks 65.3 

Stocks,  all  other 49.4 

Total  securities  of  all  classes $4, 186.5 

Formerly  national  banks  were  obliged  to  own  a  certain 
amount  of  government  bonds  and  pledge  them  with  the  Treasury 

'  Report  of  the  Comptroller  of  the  Currency,  t920.  Vol.  I,  p.  159. 


XIX]  INVESTMENTS  OF  COMMERCIAL  BANKS  265 

as  a  condition  for  organizing  under  a  federal  charter,  but  in  191 7 
(Act  of  June  21)  this  condition  was  repealed.  National  banks, 
however,  must  own  certain  issues  of  these  bonds  in  order  t©  issue 
circulating  notes;  and  they  also  hold  and  pledge  them  with  the 
Treasury  in  order  to  receive  federal  deposits.  Of  the  $2,270 
million  United  States  obligations,  held  by  national  banks,  about 
one-third  was  owned  and  deposited  to  secure  circulation.  Dur- 
ing the  financial  operations  of  the  war,  the  banks  played  a  large 
part  in  underwriting  the  loans  and  thepurchaseof  Liberty  bonds, 
Victory  notes,  war  savings  and  thrift  stamps,  and  United  States 
certificates  of  deposit, and  the  banks  still  hold  a  very  considerable 
amount  of  government  obligations  then  purchased,  in  addition 
to  the  older  issues  held  as  a  basis  for  national  bank  notes. 

The  investment  in  federal  reserve  bank  stock  is  compulsory. 
Each  member  bank  of  the  system  (a  national  bank  must  be  a 
member)  is  required  to  subscribe  6  per  cent  of  its  own  capital 
and  surplus  to  the  capital  stock  of  a  federal  reserve  bank.  As 
yet  only  half  (or  3  per  cent)  has  been  called  for. 

''Other  bonds"  represent  state,  county,  or  municipal  bonds; 
railroad  bonds;  other  public  service  bonds;  foreign  bonds;  mis- 
cellaneous bonds ;  claims,  warrants,  etc. ;  judgments  and  collateral 
trust  and  other  corporation  notes.  Holdings  of  this  character 
in  1920  amounted  to  about  one-seventh  of  loans  and  discounts. 
In  1880,  the  ratio  was  i  to  20;  in  1890,  i  to  16;  in  1900,  i  to  7; 
and  in  1910,  i  to  6.  The  marked  change  in  this  ratio  took  place 
between  1890  and  1900  when  there  was  an  enormous  amount  of 
financing  in  the  organization  of  large  corporations  in  which  many 
banks  took  an  active  part. 

Some  classes  of  bonds  are  used  by  banks  as  a  pledge  to  secure 
state  and  municipal  deposits  and  also  to  secure  acceptances  of 
foreign  banks. 

3.  Policy  as  to  Amount  of  Securities. — It  is  sometimes  stated 
that  investments  in  securities  may  properly  equal  the  sum  of 


266  BANKING  AND  CREDIT  [  XIX 

capital  stock,  surplus,  and  undivided  profits;  in  other  words, 
that  it  is  appropriate  that  a  bank  should  apply  the  funds  belong- 
ing to  stockholders  to  fixed  and  permanent  investments,  and  base 
its  current  operations  upon  deposits  which  may  be  offered  and 
loans  which  may  be  sought.  If  this  rule  be  applied  for  national 
banks  as  a  whole,  it  will  be  noted  that  in  1920  investments  in 
securities  are  much  in  excess  of  capital  (including  surplus  and 
undivided  profits).  The  holdings  of  securities  amounted  to 
$4,187  million  and  capital  to  $2,622  milHon. 

This  large  excess  of  security  investments  was  due  to  the 
liberal  purchases  by  banks  of  government  obligations  during  the 
war.  In  191 5,  before  such  demands  were  made  upon  the  banks, 
security  holdings  amounted  to  $2,038  million  and  capital  to 
$2, -07 9  million. 

Individual  banks,  however,  vary  greatly  in  their  policy  with 
regard  to  investing  in  securities.  For  example,  one  bank  may 
have  over  $2,000,000  of  securities,  and  capital  of  $300,000;  while 
another  has  securities,  amounting  to  $350,000,  and  capital  of 
$225,000.  The  loans  of  the  two  banks  are  approximately  the 
same.  It  is  evident  that  the  first  bank  finds  it  more  profitable 
to  invest  its  funds  in  long-term  securities,  while  the  second  uses 
its  funds  in  short-term  loans  which  are  quickly  liquidated.  This 
may  indicate  that  business  is  dull  where  the  first  bank  is  located 
and  that  consequently  there  is  no  demand  for  commercial  loans; 
or  it  may  mean  that  the  bank  is  using  its  resources  in  industrial 
promotions.  Of  even  more  significance  are  the  figures  for  se- 
curity holdings  when  compared  over  a  series  of  years.  If  these 
amounts  increase  with  no  increase  in  capital  or  in  loans,  it  in- 
dicates that  the  bank  is  turning  from  commercial  to  financial 
banking. 

4.  Objections  to  Large  Security  Holdings. — As  to  the  wisdom 
of  using  bank  funds  in  security  investments  to  the  extent  which 
is  now  common,  opinions  differ.     On  the  one  hand,  it  is  said  that 


XIX]  INVESTMENTS  OF  COMMERCIAL  BANKS  267 

there  is  no  difference  between  a  bond  and  a  note,  except  in  time 
of  maturity.  Investments  in  sound  securities  which  can  be  con- 
verted into  cash  serve  as  a  secondary  reserve  in  case  of  need. 
There  are  times  when  the  demand  for  loans  is  Hght,  so  that  a  bank 
cannot  employ  its  resources  profitably.  The  low  rates  of  money 
in  1903  and  1904  are  in  particular  cited  as  reasons  for  large  in- 
vestments in  those  years.  A  bank  in  buying  bonds  loans  to  a 
railroad  or  government  as  it  does  to  an  individual  on  a  note.  The 
growth  of  corporations  makes  it  necessary  for  them  to  borrow, 
but  corporate  financing  demands  a  different  form  of  credit  obHga- 
tion  than  that  used  by  individuals  or  partnerships.  If  banks 
were  prohibited  from  loaning  to  corporations  by  purchase  of 
bonds,  corporations  in  selling  bonds  would  be  obliged  to  borrow 
from  private  individuals  alone,  but  these  in  turn,  in  order  to  make 
advances,  would  borrow  from  banks,  so  that  indirectly  the  net 
results  would  be  the  same.  When  business  estabhshments  were 
small,  local  credit  w^as  sought  for;  with  the  consolidation  of 
scattered  units  into  the  large  corporation  or  trust,  local  financing 
was  abandoned  and  credit  demands  were  met  by  issues  of 
securities. 

On  the  other  hand,  it  is  urged  that  banks  by  loaning  to  cor- 
porations on  long  loans,  even  though  they  be  salable,  are  neg- 
lecting commercial  business,  which  requires  short-time  loans. 
The  function  of  a  bank  is  to  facilitate  commerce  and  not  to  operate 
as  a  finance  company.  The  latter  introduces  a  speculative  ele- 
ment into  banking,  by  making  the  banks  a  powerful  factor  in  ths 
stock  market.  Through  temporary  investments  in  bonds  a  bank 
may  be  tempted  into  promotion  of  new  securities  which  have 
unstable  value.  Moreover,  if  a  panic  occurs  good  securities  can- 
not be  sold  except  at  a  loss,  thus  crippling  the  bank  at  a  time 
when  it  should  be  able  to  support  credit. 

This  critical  attitude  may  be  illustrated  by  an  extract  from  a 
report  made  to  the  National  Monetary  Commission  in  191 1  by 
Professor  J.  H.  Hollander: 


268  BANKING  AND  CREDIT  1 XIX 

From  whatever  point  of  view  regarded  this  apparent  necessity 
under  which  American  banks  now  labor  of  tying  up  large  parts  of 
their  loanable  funds  in  stock-exchange  securities  is  unfortunate. 
It  offers  an  unhealthy  stimulus  to  corporate  financiering  by 
supplying  a  temporary  and  fictitious  market  for  investment 
securities.  It  invites  speculative  gains  and  losses  by  the  fluctua- 
tion in  market  price  in  the  interval  between  purchase  and  liquida- 
tion. It  curtails  mercantile  accommodation  by  the  bank's  re- 
luctance to  liquidate  such  securities  in  a  declining  market,  and  it 
injects  an  additional  element  of  risk  into  banking  stability  in  the 
temptation  to  invest  in  less  seasoned  and  more  productive  bonds.  ^ 

5.  Investment  in  Stocks. — As  a  rule  the  amount  of  corpora- 
tion stocks  which  a  national  bank  holds  is  small.  Stock  is  of  a 
more  speculative  character  than  bonds.  A  stock  does  not  have 
maturity,  while  a  bond  is  ordinarily  a  promise  to  pay  with  a 
definite  period  to  run.  Under  a  ruling  of  the  Comptroller  of  the 
Currency,  a  national  bank  is  not  permitted  to  invest  in  a  stock 
except  when  taken  in  payment  of  debt,  and  then  may  hold  it 
only  for  a  limited  time.  During  the  war  permission  was  granted 
to  invest  not  exceeding  10  per  cent  of  the  bank's  capital  and 
surplus  in  any  domestic  corporation  engaged  in  foreign  financial 
operations  necessary  to  facilitate  the  export  of  commodities. 

6.  Banking  House  and  Equipment. — Other  items  of  invest- 
ment appearing  among  resources  are  "Banking  house,"  "Furni- 
ture and  fixtures,"  and  "Other  real  estate  owned."  The  first 
two  are  self-explanatory.  A  national  bank  is  not  permitted  by 
law  to  invest  in  real  estate,  except  as  may  be  necessary  to  carry 
on  its  business.  It  may,  however,  if  permission  be  granted  by 
the  Comptroller  of  the  Currency,  own  a  building  larger  than  is 
needed  for  its  own  requirements  and  rent  the  remainder.  The 
object  of  the  law  is  to  prevent  investment  in  property  which  is 
not  readily  salable.     The  item, "Other  real  estate  owned, "is not 


'  Bank  Loans  and  Stock  Exchange  Speculation,  p.  18. 


XIX  I  I.WESTMExNTS  OF  COMMERCIAL  BANKS  269 

a  contradiction  of  this  principle.  It  refers  to  real  estate  acquired 
in  the  settlement  of  loans  which  debtors  have  not  paid.  The 
bank,  however,  is  under  obligation  to  dispose  of  such  holdings 
within  a  limited  period. 

References 

VVesterfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  IV,  pp.  1022- 
1028. 


CHAPTER  XX 

CASH   HOLDINGS   AND   RESERVE   OF   A 
COMMERCIAL   BANK 

I.  Need  of  a  Reserve. — Reserve  has  a  special  technical  signifi- 
cance in  American  banking  practice,  since  both  state  and  federal 
statutes  require  banks  to  maintain  a  reserve  against  deposits. 
The  nature  of  the  reserve  has  varied;  it  may  consist  of  cash  in  the 
bank's  own  vault ;  or  a  part  may  be  cash  and  a  part  in  the  keeping 
of  other  banks;  or  the  entire  amount  may  be  represented  by  bal- 
ances v^^ith  other  banks.  A  bank  may  also  be  required  to  keep  a 
reserve  against  its  note  issues  as  well  as  against  its  deposits.  All 
of  these  methods  have  been  in  operation  at  one  time  or  another 
in  American  banking  history. 

A  distinction  is  to  be  made  between  cash  and  reserve.  Cash 
is  actual  money  which  the  bank  holds  in  its  vault,  while  reserve 
may  include  balances  with  other  banks  which  can  be  drawn  upon 
immediately  to  reinforce  cash.  A  bank  needs  to  hold  cash  for 
three  purposes: 

1.  To  meet  the  demands  of  depositors  who  wish  actual 

money. 

2.  To  redeem  bank  notes,  if  presented. 

3.  To  pay  to  borrowers  who  wish  immediate  cash  instead  of 

credit  as  a  deposit  account. 

Few  national  bank  notes,  however,  are  presented  for  redemp- 
tion at  the  bank's  own  counter,  as  their  security  is  never  in  doubt, 
so  that  the  need  of  money  in  hand  for  this  purpose  may  be  dis- 
regarded. Few  borrowers  take  any  large  amount  of  actual  cash 
and  the  strain  from  this  demand  is  small.  The  principal  impor- 
tance of  a  cash  reserve  is  to  meet  the  demands  of  depositors  who 


XX  1  COMMERCIAL  BANK  RESERVES  27I 

need  cash  and  to  make  payment  for  current  operating  expenses. 
Depositors  do  not  all  draw  checks  simultaneously.  Inasmuch  as 
a  bank  is  constantly  receiving  checks  drawn  against  other  banks 
which  tend  to  counterbalance  the  amounts  drawn  against  it,  ex- 
perience shows  that  it  is  safe  to  carry  on  its  operations  with  but 
a  small  amount  of  cash. 

2.  Reserve  of  National  Banks  under  Old  Law. — In  order  to 
understand  the  present  law  governing  the  character  and  amount 
of  reserves  required  of  national  banks,  it  is  desirable  to  describe 
briefly  the  older  reserve  system  in  operation  before  19 14.  Until 
that  year  national  banks  were  required  to  keep  reserves  in  lawful 
money  as  follows: 

1.  Country  banks,  15  per  cent,  of  which  three-fifths  might 

be  deposited  in  a  bank  in  a  reserve  city. 

2.  Reserve  city  banks,  25  per  cent,  of  which  one-half  might 

be  deposited  in  a  bank  in  a  central  reserve  city  (New 
York,  Chicago,  St.  Louis). 

3.  Central  reserve  city  banks,  25  per  cent  in  their  own  vaults. 
A  central  reserve  city  must  have  a  population  of  200,000; 

and  a  reserve  city  25,000  (previous  to  1903,  50,000).  Not  all 
cities,  however,  which  can  satisfy  the  population  requirements 
are  made  central  reserve  cities  or  reserve  cities.  There  are  but 
three  central  reserve  cities — New  York,  Chicago,  and  St.  Louis — 
and  about  60  reserve  cities.  All  banks  outside  of  the  central 
reserve  cities  and  reserve  cities  are  called  ''country"  banks. 

Lawful  money  included  gold  and  silver  coins,  gold  and  silver 
certificates,  legal  tender  notes,  and  clearing-house  certificates 
(see  Chapter  XXI)  issued  against  coin  or  legal  tender.  Banks 
were  also  permitted  to  include  in  this  reserve  the  5  per  cent  re- 
demption fund  deposited  with  the  Treasurer  of  the  United  States. 
A  bank  might,  therefore,  carry  part  of  its  reserve  in  its  own 
vaults,  and  a  part  with  other  banks  which,  to  that  extent,  acted 
as  their  agents. 


272 


BANKING  AND  CREDIT 


XX 


3.  Reserve  Requirements  Illustrated.— Under  this  reserve 
system  (treating  the  note  redemption  fund  in  the  United  States 
Treasury  as  in  the  bank's  vault),  deposits  of  $10  million  in 
country  or  non-reserve  city  banks,  would  call  for  a  cash  reserve 
to  be  kept  in  their  own  vaults  of  but  $600,000.  They  would 
carry  and  count  as  reserve  $900,000  on  deposit  with  reserve  city 
banks.  These  reserve  city  banks  would  be  required,  to  protect 
the  deposits  of  the  country  banks,  to  have  in  their  vaults  cash  to 
the  amount  of  only  $112,500,  and  might  deposit  $112,500  in 
central  reserve  cities,  who,  in  turn,  would  have  to  have  on  hand  25 
per  cent,  or  but  $28,125  in  cash.  This  may  be  summarized  in 
the  form  of  a  table : 


Cash  Reserve  on  Deposits  of  $10,000,000  in  Country  Banks 


Amount  of 
Deposits 

Cash  Reserve 

in  Vaults 

Deposited 

with  Reserve 

Agents 

Country  banks 

$10,000,000 
900,000 

112,500 
III, 012, 500 

$600,000 
112,500 

28,125 

$900,000 
112,500 

Reserve  city  banks  (amount 
as    above    deposited    by 
country  banks) 

Central  reserve  city  banks 
(amount     as     above     de- 
posited   by    reserve    city 
banks) 

Total 

$740,625 

$1,012,500 

Per  cent  of  total  deposits . . . 
Per  cent  of  deposits  in  coun- 
try banks 

63/4 

7  2/5 

9  1/5 
10  1/8 

Amount  of  cash  outside  original  country  banks   $140,625,  or  1.4  per  cent. 


It  will  thus  be  seen  that  the  country  bank  was  obliged  to  keep 
6  per  cent  on  hand  in  cash,  and  of  the  country  bank's  reserve 
deposits  the  city  banks  kept  1.4  per  cent  on  hand  in  cash.  There 
might  therefore  be  but  7.4  per  cent  of  cash,  or  $740,625  held 


XX  1  COMMERCIAL  BANK  RESERVES  273 

unloaned  anywhere  against  this  deposit  of  $10  million  in  the 
country  banks.' 

Under  this  system  any  city  which  had  a  population  of  25,000 
could  become  a  reserve  city  on  the  apphcation  of  three-fourths 
of  the  national  banks  in  that  city.  To  become  a  central  reserve 
city  a  population  of  200,000  was  required.  There  were  nearly 
50  reserve  cities  (only  one,  Boston,  in  New  England),  and  only 
three  central  reserve  cities — New  York,  Chicago,  and  St.  Louis. 
Other  cities  might  have  qualified  as  central  reserve  cities  but  did 
not  seek  this  distinction,'  as  it  would  have  obliged  all  national 
banks  in  such  city  to  increase  their  cash  reserves  to  25  per  cent. 
Although  any  national  bank  in  a  reserve  city  might  act  as  a 
reserve  agent  upon  permission  of  the  Comptroller  of  the  Cur- 
rency, this  service  was  concentrated  in  the  hands  of  but  a  few 
banks.  In  New  York  six  banks  held  three-quarters  of  the  re- 
serves for  country  banks,  and  in  Boston  the  same  proportion  was 
held  by  two  banks. 

Country  banks  availed  themselves  of  the  privilege  of  keeping 
a  part  of  their  reserve  in  reserve  cities  for  two  reasons:  (i)  be- 
cause the  reserve  banks  paid  a  small  rate  of  interest,  generally 
2  per  cent  on  the  balances  deposited,  so  that  the  reserve  was 
not  altogether  profitless;  and  (2)  country  banks  must  keep  funds 
in  a  bank  in  a  large  commercial  city  in  order  to  oblige  their  cus- 
tomers who  wish  to  buy  exchange  to  make  payments  in  these 
centers. 

4.  Reserve  under  the  Federal  Reserve  Law. — Under  the  old 
law  all  cash  which  a  national  bank  held  might  be  counted  as  part 
of  its  reserve.  The  federal  reserve  law,  enacted  in  19 13  (amended 
June  21,  191 7),  changed  this.  A  distinction  is  made  between 
cash  and  reserve.  The  reserve  is  kept  in  the  form  of  credits 
with  a  federal  reserve  bank.  Cash  in  bank  no  longer  constitutes 
part  of  the  reserve,  but  simply  serves  the  purpose  of  till  money. 

'  Report  of  the  Comptroller  of  the  Currency.  1907,  P-  72. 
18 


274  BANKING  AND  CREDIT  [  XX 

The  new  law  requires  every  member  bank  in  the  federal  reserve 
system  to  maintain  in  a  federal  reserve  bank  a  deposit  known  as 
"reserve  balance"  or  "due  from  federal  reserve  bank,"  to  secure 
the  member  bank's  liability  to  its  own  depositors.  The  propor- 
tion of  such  reserve  varies,  as  under  the  old  law,  depending  upon 
whether  the  institution  be  a  country  bank,  is  in  a  reserve  city, 
or  in  a  central  reserve  city.  The  ratios  are  7,  10,  and  13  per  cent 
respectively  against  demand  deposits,  and  3  per  cent  against 
time  deposits  for  all  institutions,  without  regard  to  their  location. 
Under  the  former  system  the  cash  holdings  of  banks  were  scat- 
tered and,  particularly  in  times  of  emergency,  could  not  be  made 
effective  when  there  was  the  greatest  strain;  under  the  new  sys- 
tem the  cash  reserve  is  held  by  the  federal  reserve  banks  to  secure 
their  liabilities  to  the  member  banks  and  is  thus  centralized  in  12 
large  reservoirs.  The  significance  of  this  will  be  further  explained 
in  a  subsequent  chapter. 

A  "country  "bank  needs  less  reserve  than  a  bank  in  a  city  of 
metropolitan  size,  for  the  withdrawals  of  cash  are  likely  to  be 
less.  There  is  a  greater  probability  that  checking  accounts  will 
be  settled  simply  by  transfer  of  credits  within  the  bank;  and 
withdrawals  for  settlement  with  other  banks  are  less  likely  to  be 
urgent.  The  variations  in  reserve  requirements  according  to 
whether  a  bank  be  "country,"  in  a  reserve  city,  or  in  a  central 
reserve  city,  with  the  new  reserve  rules  of  the  federal  reserve  law 
are  not  altogether  logical.  Formerly  it  was  clearly  necessary  that 
a  reserve  city  bank  should  hold  a  larger  reserve  than  a  country 
bank,  as  it  might  hold  the  reserves  of  country  banks  w^hich  could 
be  called  for  at  any  time  the  latter  found  advantageous.  The 
amount  of  such  withdrawals  could  not  be  calculated  with  as  great 
precision  as  the  withdrawals  of  cash  by  individual  depositors. 
Now,  however,  no  national  bank  keeps  the  reserves  of  other 
banks  and  consequently  this  protection  is  no  longer  needed.  The 
federal  reserve  system  inherits  the  classification  of  the  old  system 
with  the  result  that  a  bank  in  a  city  as  large  as  Providence, 


XX 


COMMERCIAL  BANK  RESERVES 


75 


Rhodelsland.with  a  population  of  237,595  (1920)  holds  a  reserve 
of  but  7  per  cent,  while  a  bank  in  a  reserve  city,  as  Peoria,  Illinois, 
with  a  population  of  76,121,  is  obliged  to  hold  10  per  cent.  In 
so  far,  however,  as  banks  hold  funds  of  banks  in  other  cities  to 
meet  the  demand  for  domestic  exchange,  the  need  of  variations 
in  reserve  requirements  is  justified. 

In  addition  to  the  reserve  carried  with  the  federal  reserve 
banks,  the  banks  hold  cash  in  their  own  vaults.  This  may  be 
regarded  as  till  money  needed  to  meet  the  current  day-to-day 
demand  of  customers  for  actual  cash.  The  amount  thus  re- 
quired is  determined  by  experience  rather  than  by  law,  and  is 
much  less  than  is  generally  supposed;  in  1920  it  was  less  than  5 
per  cent  of  all  deposits.^ 

5.  Amount  of  Reserve  Held.- -The  following  table  shows  the 
amount  of  deposits,  the  reserve  required,  the  amount  held  by 
federal  reserve  banks,  and  the  per  cent  of  actual  reserve  to  de- 
posits, for  national  banks  in  the  several  groups,  September  12, 
1919:^ 

Reserve  Position  of  National  Banks,  September  12,  1919 

(Amounts  in  thousands) 


Locality 

Deposits 

Reserve 
Required 

Held  by  Federal 
Reserve  Banks 

Per  Cent 
of  Deposits 

Central  reserve  cities: 

New  York 

Chicago 

St.  Louis 

52,586,604 

629,184 

160,342 

3,604,661 

5,293,481 

5336,259 

81,794 

20,844 

360,466 

370,842 

$362,74.5 

82,450 

19,932 

365,920 

398,488 

14.02 
13-10 
12.43 

Country  banks 

7. S3 

All  banks 

$12,274,272 

$1,170,205 

$1,229,533 

10.02 

^  Report  of  Comptroller  of  Currency,  1920,  Vol.  I,  p.  115. 
^  Report  of  Comptroller  of  Currency.  1919,  Vol.  II,  pp.  224-2 


276  BANKING  AND  CREDIT  [XX 

Taking  the  country  as  a  whole,  the  reserves  of  national  banks 
were  $59  million  in  excess  of  the  legal  requirement. 

The  amount  of  reserve  which  a  bank  has  in  proportion  to  its 
liabilities  is  not  necessarily  a  measure  of  its  strength.  Idle  money 
in  the  vaults  of  the  bank  is  not  earning  anything.  A  bank's 
profits  come  from  its  loans  and  investments.  A  well-managed 
bank  therefore  seeks  to  invest  all  its  funds  beyond  what  is  needed 
to  meet  current  demand,  maintain  public  confidence,  and  satisfy 
legal  requirements  as  to  reserves.  It  is  the  quality  of  the  loan 
account,  by  far  the  largest  item  among  the  resources,  which  in  the 
last  analysis  determines  whether  the  depositor  is  amply  protected. 

6.  Relation  of  Reserve  to  Loans  and  Deposits. — The  amount 
of  reserve  bears  an  intimate  relation  not  only  to  deposits  but  also 
to  loans,  for,  as  seen  in  the  chapter  on  deposits,  loans  and  deposits 
are  in  great  measure  complements  of  each  other.  Disregarding, 
for  the  moment,  the  provisions  of  the  Federal  Reserve  Act  pro- 
viding for  the  holding  of  the  reserve  as  a  credit  balance  by  the 
federal  reserve  banks,  instead  of  allowing  it  to  rest  in  the  vaults 
of  the  individual  banks,  this  relationship  of  loans,  deposits,  and 
reserve  may  be  illustrated  as  follows :  There  is  but  a  single  bank 
in  a  given  community  and  this  has  a  capital  of  $100,000.  The 
balance  sheet  reads: 

I 
Cash $100,000       Capital $100,000 

It  is  now  assumed  that  there  are  100  customers  of  the  bank,  all 
of  whom  are  depositors.  It  is  also  assumed  that  the  bank  is  re- 
quired to  keep  a  certain  cash  reserve  against  its  deposits,  say,  10 
per  cent.  The  clients  of  the  bank  deposit  $10,000  in  cash,  an 
average  of  $100  each.     The  balance  sheet  then  reads: 


Cash $1 10,000       Capital $100,000 

Deposits 10,000 

$110,000  $110,000 


XXI  COMMERCIAL  BANK  RESERVES  277 

One  of  the  customers,  A,  of  the  bank  now  apphes  for  a  loan. 
If  he  wishes  cash,  the  bank  can  loan  $109,000  without  impairing 
the  reserve  protection  of  deposits.  Omitting  all  calculations  of 
interest  or  discount  and  the  item,  undivided  profits,  the  balance 
sheet  will  read : 

3 

Loans $109,000      Capital $100,000 

Cash 1,000       Deposits 10,000 

$110,000  $1I(),()0() 

What  becomes  of  the  cash  loaned  out?  On  the  assumption 
that  this  is  a  self-contained  community,  that  there  is  no  other 
bank  into  which  the  cash  can  flow,  and  that  the  cash  will  not  be 
transferred  to  any  other  community,  it  is  obvious  that  it  will  not 
be  long  before  it  flows  back  to  the  bank.  Some  of  the  other  99 
customers  of  the  bank  will  receive  it  and  deposit  it  in  the  bank. 
If  it  be  assumed  that  the  community  already  has  all  the  pocket 
and  till  money  needed  in  ordinary  every-day  exchange,  all  this 
cash,  $109,000,  will  reappear  at  the  bank  in  deposits.  The 
balance  sheet  will  then  read : 

4 

Loans .     $109,000      Capital $100,000 

Ca.sh 1 10,000.      Deposits 1 19,000 

$219,000  $219,000 

But  the  borrower  may  not  take  out  his  loan  in  cash;  he  may 
receive  a  credit  as  a  deposit  and  the  statement  will  read: 

5 

Loans $109,000      Capital $100,000 

Cash 1 10,000       Deposits 1 19,000 

$219,000  $219,000 

This  is  the  same  statement  as  No.  4.  The  borrower  now 
proceeds  to  make  payments  in  checks,  drawing  against  his  de- 


278  BANKING  AND  CREDIT  [XX 

posits.  His  checks  are  received  by  other  business  men  in  the 
town  and  are  by  them  deposited.  A's  deposit  is  decreased,  but 
B's  and  C's  deposits  arc  increased  by  the  same  amount,  and  there 
will  be  no  change  in  the  balance  sheet,  even  if  A  checks  out  all  of 
his  own  deposit. 

Can  the  bank  make  further  loans  and  if  so,  to  what  extent? 
B  may  now  apply  for  a  cash  loan.  The  bank,  as  before,  must 
keep  a  cash  reserve  of  lo  per  cent  on  its  deposits  of  $iig,ooo,  or 
$11,900.  The  bank  can  thus  loan  $98,100,  and  the  balance  sheet 
reads: 

6 

Loans $207,100       Capital $100, oco 

Cash II  ,900       Deposits 1 19,000 

$219,000  $219,000 

Again  the  cash  is  passed  from  hand  to  hand  and  within  no 
long  period  is  again  deposited.     The  statement  then  appears: 

7 

Loans $207 , 1 00       Capital $1 00,000 

Cash 110,000       Deposits 217,100 


}!.3i7,ioo  $317,100 

Or,  if  borrower  B  does  not  take  cash  but  a  deposit  credit,  the 
statement  will  at  once  appear  as  in  No.  7. 

This  process  can  be  continued  until  deposits  reach  $1,100,000, 
or  ten  times  the  cash  reserve.  Deposits  in  these  transactions 
are  due,  not  to  any  increase  in  cash,  but  to  loans  which  have  been 
advanced  upon  satisfactory  collateral. 

In  brief,  if  there  were  a  single  bank  with  which  all  the  people 
of  the  business  community  did  their  banking,  and  if  the  cash 
reserve  against  deposits  should  be  set  at  various  times  at  5,  10, 
and  16  2/3  per  cent,  the  amount  by  which  the  bank  could  expand 
its  loans  for  each  additional  dollar  of  cash  deposited  would  be 
$19,  $9,  and  $5,  respectively.-^     On  the  other  hand,  where  several 

■*  The  dollar  deposited  will,  of  course,  require  its  own  reserve. 


XX]  COMMERCIAL  BANK  RESERVES  279 

banks  are  established  in  the  community  there  is  no  possibiHty  of 
any  one  being  able  to  expand  its  loans  ten  times  for  each  cash 
deposit  and  maintain  cash  reserves  of  10  per  cent.  This  is 
because  of  the  cash  withdrawals  and  the  necessity  for  settling 
unfavorable  clearing-house  balances.  However,  for  the  banking 
system  as  a  whole  the  possibiHty  of  expanding  loans  and  deposits 
is  quite  the  same  as  already  described  where  a  single  bank  for  the 
community  has  been  assumed. 

7.  Relation  of  Reserve  to  Loans  and  Deposits  for  Individual 
Banks. — If  there  are  several  banks  in  a  community,  involving 
withdrawals  of  cash  from  one  to  another,  each  bank  must  retain 
a  larger  reserve  than  the  foregoing  analysis  would  imply.  As- 
sume that  in  a  certain  community  there  are  a  number  of  banks 
and  that  they  handle  all  the  local  business;  also  assume  that 
each  time  a  loan  or  discount  is  made,  80  per  cent  is  withdrawn  by 
check,  the  20  per  cent  being  left  on  deposit;  and  in  addition  that 
the  banks  are  required  to  keep  cash  reserves  of  10  per  cent  against 
deposit  liabihties.  In  order  to  simplify  the  illustration  it  is  also 
assumed  that  the  80  per  cent  cash  withdrawal  from  bank  W  is  paid 
to  individual  depositors  of  bank  X,  etc.  The  cash  withdrawal 
from  one  bank  thus  becomes  an  additional  cash  deposit  for  the 
next  bank  which  extends  loans  and  discounts  as  before  and  in 
turn  is  subject  to  a  similar  percentage  of  cash  withdrawals. 
The  accompanying  table  starts  with  the  receipt  by  bank  W  of 
$10,000  cash  deposits.  On  the  basis  of  this  cash  the  bank  de- 
cides to  extend  its  loans  and  discounts  to  a  point  where  the 
resulting  net  additional  deposits,  after  allowing  for  a  cash  with- 
drawal of  80  per  cent  of  the  proceeds  of  these  loans  and  discounts, 
leaves  the  bank  with  the  necessary  cash  reserve  of  10  per  cent. 

The  amount  by  which  deposits  created  by  loans  and  discounts 
may  be  expanded  on  the  basis  of  a  certain  amount  of  additional 
cash  can  be  determined  either  by  a  mathematical  equation  or  by 
process  of  trial  and  error.     For  purposes  of  simplifying  the  illus- 


280 


BANKING  AND  CREDIT 


IXX 


tration  the  latter  plan  has  been  chosen  and  a  reserve  of  slightly 
less  than  lo  per  cent  is  maintained.  It  is  thus  found  that  bank 
W  can  expand  its  loans  approximately  $i i,ooo  on  the  basis  of  the 
receipt  of  $10,000  cash  deposits.  After  cash  withdrawals  have 
been  made  the  net  additional  cash  leaves  a  reserve  of  9.836  per 
cent,  or  slightly  less  than  the  required  10  per  cent.  The  actual 
possible  expansion  of  loans,  therefore,  under  the  conditions  given 
would  be  sHghtly  less  than  $11,000.  The  cash  withdrawal  of 
$8,800  from  bank  W  becomes  an  additional  cash  deposit  for  bank 
X,  which  goes  through  the  same  operations. 

Table  Showing  Relation  of  Reserve  to  Loans  and  Deposits  for 
Individual  Banks 


(a) 

(b) 

(c) 

(d) 

(e) 

(f) 

(g) 

(h) 

Bank 

Additional 

Cash 
Deposits 

Additional 
Deposits 
Created  by 
Loans  and 
Discounts 

Cash  With- 
drawal 80 
Per  Cent 
of  Column 

(c) 

Net 

Additional 

Depos'ts 

Created  by 

Loans  and 

Discounts 

Columns 

(c)-(d) 

Net 
Additional 

Cash 
Columns 
(b)-{d) 

Total  Net 
Additional 
Deposits 
Columns 
(b)  +  (c)- 
(d) 

Percentage 

of  Cash 
Reserve,  or 
Ratio  of 
Column 
(f)  to  (g) 

w 

X 
Y 
Z 

$10,000.00 

8,800.00 

7,744-00 
6,814.72 

$11,000.00 
9,680.00 

8,518.40 
7,496.19 

$8,800.00 

7,744-00 
6,814.72 
5,996.95 

$2,200.00 
1,936.00 

1,703.68 
1,499-24 

$1,200.00 

1,056.00 

929.28 

817-77 

$12,200.00 
10,736.00 
9,447.68 
8,313-96 

9.836 
9-836 
9.836 
9-836 

It  will  be  observed  from  the  table  that  each  bank  on  the  basis 
of  a  given  cash  deposit  is  able  to  increase  its  loans  no  per  cent 
of  the  sum  so  received,  while  the  resulting  deposits,  after  the  with- 
drawal of  80  per  cent  of  the  loans,  are  approximately  1 20  per  cent 
of  the  cash  deposits.  To  be  more  exact,  column  (g)  in  each  case 
is  22  per  cent  greater  than  column  (b),  assuming  a  percentage  of 
cash  reserve,  column  (h),  of  9.836  instead  of  10. 

If  the  tabulation  were  carried  out  for  other  banks,  column 


XX]  COMMERCIAL  BANK  RESERVES  281 

(g),  Net  Additional  Deposits,  would  continue  to  show  a  con- 
stantly decreasing  figure  for  each  successive  bank  and  the  total 
of  this  column  would  be  the  amount  by  which  all  banks  in  the 
aggregate  could  expand  their  deposits  arising  from  loans.  This 
total  is  $101,667,  or  slightly  more  than  10  times  the  original  addi- 
tional cash  deposit  of  $10,000  in  bank  W.  If  a  reserve  of  exactly 
10  per  cent  instead  of  9.836  per  cent  had  been  maintained,  the 
total  expansion  would  be  precisely  $100,000  for  the  banking  sys- 
tem as  a  whole,  as  it  was  for  the  single  bank  which  we  assumed 
did  all  the  business  (page  278). 

8.  Export  and  Import  of  Gold. — One  further  observation 
should  be  made.  If  the  original  cash  deposit  of  $10,000  in 
bank  W  has  resulted  from  withdrawals  from  seme  other  bank  in 
the  same  country,  there  is  no  new  basis  for  expansion  of  loans  for 
the  banking  system  as  a  whole.  But  if  this  cash  represents  gold, 
imported  or  mined  in  the  country,  expansion  for  banks  in  the 
aggregate  would  be  possible.^ 

Suppose,  for  example,  that  all  national  banks  held  $884  mil- 
lion of  cash  reserve,  the  law  requiring  a  10  per  cent  legal  reserve 
against  $8,840  million  of  deposits;  $1  of  cash  supports  $10  of 
deposits.  If  cash  were  reduced  by  $50  million  withdrawal 
through  export  of  gold,  the  ratio  of  cash  reserve  against  deposits 
would  be  below  the  legal  limit.  The  only  way  to  retain  the  legal 
equilibrium  between  cash  and  deposits  would  be  to  reduce  the 
loans,  thus  decreasing  the  deposits.  If  $884  million  cash  be  re- 
duced to  $834  million,  the  new  reserve  could  support  only  $8,834 
million  of  deposits,  and  it  would  consequently  be  necessary  to 
reduce  loans  by  $500  million.  The  decrease  in  loans  does  not  of 
itself  increase  cash,  but  it  reduces  the  amount  of  deposits.  So, 
too,  an  influx  of  gold  will  increase  the  loaning  power  of  banks 
many  times  the  amount  of  the  gold,  if  the  loans  are  taken  in  the 
form  of  deposit  accounts. 

5  See  note  at  end  of  chapter. 


282  BANKING  AND  CREDIT  [  XX 

The  illustration  given  above  presupposes  the  exportation  or 
importation  of  gold.  If  the  transfer  of  $50  million  were  made 
within  the  country,  there  would  be  no  change  in  the  loaning  power 
of  all  banks,  for  the  withdrawal  from  one  bank  would  reappear  as 
cash  in  another  bank.  It  would  then  perform  the  same  service 
as  in  the  bank  from  which  it  was  transferred,  so  that  theoretically 
there  would  be  no  change  in  the  total  loans  and  deposits  of  all 
banks.  Withdrawal  of  cash  (gold)  by  export,  or  its  gain  by 
import,  therefore,  has  far  more  important  consequences  than 
domestic  losses  or  gains  of  cash  which  do  not  affect  the  total 
volume  of  cash  within  the  country. 

9.  Procedure  in  Maintenance  of  a  Reserve. — If  a  bank  has  a 
reserve  which  is  near  the  legal  limit,  it  must  decline  to  make  fur- 
ther loans  even  if  there  were  an  informal  agrejment  that  a  con- 
siderable part  of  the  loan  were  to  be  left  on  deposit  and  not  with- 
drawn in  cash. 

Although  there  is  no  penalty  imposed  upon  a  bank  when  its 
reserve  is  less  than  the  legal  ratio,  it  is  under  pressure  by  the 
Comptroller  of  the  Currency  to  restore  its  reserve  as  quickly  as 
possible,  and  the  National  Banking  Act  forbids  the  bank  to  make 
further  loans  or  to  declare  a  dividend  until  the  deficit  is  made 
good.  There  are  various  methods  by  which  a  bank  can  increase 
its  reserve,  but  generally  it  is  effected  by  decreasing  its  loans 
rather  than  by  the  sale  of  securities  or  increase  of  cash  through 
deposits.  It  has  been  explained  that  deposits  are  largely  due  to 
loans  and  do  not  bring  actual  cash  into  a  bank.  To  increase 
deposits  through  loans  obviously  increases  the  amount  which 
must  be  held  in  reserve  and  places  the  bank  in  a  still  more  pre- 
carious condition;  the  payment  of  outstanding  loans  will  increase 
cash  or,  if  paid  by  checks  drawn  on  the  bank  itself,  reduce  de- 
posits, in  either  case  increasing  the  ratio  of  cash  reserve  to 
deposits. 

In  contracting  its  loans  a  bank  in  normal  condition,  and  even 


XX]  COMMERCIAL  BANK  RESERVES  283 

in  periods  of  emergency,  rarely  takes  the  position  of  refusing  to 
loan,  especially  to  its  long-established  clients.  Such  refusal 
would  create  irritation  and  be  destructive  of  the  good-will  which 
is  so  large  an  asset  in  successful  banking.  Borrowing,  however, 
is  discouraged  by  an  advance  in  the  discount  or  loaning  rates;  and 
as  a  portion  of  the  bank's  loans,  particularly  in  the  larger  cities, 
are  demand  loans,  this  advance  will  lead  to  immediate  payment 
by  some  borrowers  and  tend  to  lessen  the  strain  which  other 
borrowers  might  exert.  As  time  loans  are  constantly  niaturing, 
the  bank  is  thus  enabled  to  maintain  its  reserve  above  the  danger 
point.  On  the  other  hand,  if  there  is  surplus  cash  the  bank  will 
lower  its  discount  rate  so  as  to  attract  borrowers  and  thus  keep 
its  funds  profitably  employed.  It  is  thus  through  its  loaning 
department  that  the  bank  adjusts  its  reserve. 

With  the  establishment  of  the  federal  reserve  banking  sys- 
tem the  maintenance  of  the  reserve  of  the  individual  bank  has 
been  made  much  easier.  The  member  bank  may  not  only  trans- 
fer cash  to  the  federal  reserve  bank  but  also  rediscount  some  of 
its  commercial  paper  with  the  federal  reserve  bank  and  obtain  a 
credit  in  return.  Through  these  credits  the  bank  is  able  to 
meet  demands  which  would  otherwise  reduce  its  reserve.  The 
significance  of  these  changes  in  reserve  methods  is  discussed  in 
subsequent  chapters. 

10.  Computation  of  Reserve  of  a  Member  Bank. — Under 
present  procedure  the  reserve  of  all  banks  and  trust  companies 
which  are  members  of  the  federal  reserve  system  are  maintained 
in  a  federal  reserve  bank.  Using  the  balance  sheet  shown  on 
pages  138-140,  the  computation  is  made  as  follows: 

Demand  Deposits 

I.  Deposits,  other  than  United  States  government  and 

bank  deposits,  payable  within  30  days $1,546,145.47     (33) 

Less:  "our  checks"(  17  d,  a) 60,944.83 

$1,485,200.64 


284  BANKING  AND  CREDIT  [XX 

Due  to  Banks 

2.  Balance  due  to  all  banks  other 

than  federal  reserve  bank*. . .       $62,829.70     (30) 

3.  Balance  due  to  federal  reserve 

bank — deferred  credits •   24,829.81      (28) 

4.  Cashier's,  secretary's,  or  treas- 

urer's  checks  on  own   bank 

outstanding 78,846.55     (34) 

5.  Certified  checks  outstanding  ..  .  16,482.26     (31) 


Total  due  to  banks  (items 

2,  3,  4,  and  5) $182,988.32 

Less:  Deductions  from  Bank  Deposits 

6.  Balances  due  from  hanks  other 

than  federal  reserve  bank  and       $39.7i3-i7     (13b) 
foreign  banks 1 ,838.93     ( 1 4) 

7.  Items  with  federal  reserve  bank 

in  process  of  collection 

8.  Exchanges  for  clearing  house 

9.  Checks  on  other  banks  in  same 

place 1,648.91     (16) 

Total      deductions      from 
bank  deposits   (items  6, 

7,  8,  and  9) $43,201.01 

TO.  Net  balance  due  to  banksf $139,787.31 

11.  Total  demand  deposits  (items  I  and  10) $1,624,987.95 

Time  Deposits 

12.  Ravings    accounts    (subject    to 

not  less  than  30  days'  notice 

before  payment) 

13.  Certificates  of  deposit  (subject 

to    not    less    than    30    days' 

notice  before  payment) 

14.  Other    deposits    payable    only 

after  30  days 

15.  Postal  savings  deposits $7,893.25     (41) 

16.  Total  time  deposits  (items  12, 

13,  14,  15) $7,893.25 


*" Balances  due  to  all  banks  other  than  federal  reserve  bank"  (item  2,  demand  de- 
posits) should  include  balances  due  to  foreign  banks. 

t  Should  the  aggregate  "due  from  banks "  (items  6,  7.  8,  9)  exceed  the  aggregate  "due 
to  banks"  (items  2,  3,  4,  s)  both  amounts  must  be  omitted  from  the  calculation. 


XX]  COMMERCIAL  BANK  RESERVES  2S5 

Reserve  Required 

Demand  deposits: 
Banks  in  central  reserve  cities, 

13%  of  item  II 
Banks  in  other  reserve  cities, 

10%  of  item  II 
Banks   outside    reserve    and 

central  reserve  cities,  7%  of 

item  II $113,749.15 

Time  deposits: 

All  banks  3%  of  item  16 236.79 

Total  reserve  to  be  maintained 

with  federal  reserve  bank $1 13,985.94 

Reference  to  item  1 1  of  resources  in  the  balance  sheet  shows 
that  the  bank  has  as  hiwful  reserve  with  the  federal  reserve  bank 
$168,016.50,  which  is  in  excess  of  the  legal  requirement. 

In  computing  the  reserve  certain  deductions  from  deposits 
are  allowed.  The  bank  not  only  holds  the  deposits  of  other 
banks  but  it  has  deposits  in  other  banks.  If  the  latter  (not  in- 
cluding the  deposit  in  the  federal  reserve  bank)  is  less  than  the 
former,  that  amount  may  be  subtracted  in  order  to  determine  the 
net  amount  of  bank  deposits  for  which  the  bank  is  obliged  to 
maintain  a  reserve.  The  amount  "due  to  banks"  includes  not 
only  items  28  and  30  in  the  balance  sheet,  but  also  certified  checks 
(31)  and  cashier's  checks  (34),  listed  among  liabilities  as  "certi- 
ficates of  deposit."  From  the  amount  "due  to  banks"  are 
subtracted  items  13(b),  "due  from  banks,"  and  14(a),  "our 
checks." 

The  item  of  "our  checks,"  $60,944.83,  is  regarded  as  a  cash 
item.  These  checks  are  held  as  cash  each  night,  owing  to  the 
fact  that  the  ledgers  close  at  noon  each  day  and  the  checks  do 
not  go  on  to  the  individual  accounts  on  the  ledgers  until  the 
following  day.  These  checks  have  been  actually  paid  and  are 
held  in  cash  as  above  stated,  and  are  thus  deductible  from 
deposits. 


I 

li 

{c 

-  Re) 

c  - 

-  Re 

R 

c 

(I 

-  R) 

^86  BANKING  AND  CREDIT  \  XX 

Note:  Professor  Chester  A.  Phillips  in  a  recent  notable  volume  on 
"Bank  Credit"  has  made  a  clear  mathematical  exposition  of  the  limita- 
tions which  restrict  individual  banks  operating  in  a  group  when  each 
is  subject  to  demand  from  the  others.  If  there  be  but  one  bank  or  if 
all  banks  be  amalgamated  in  one  system,  the  net  deposit  of  a  given 
amount  of  cash,  c,  against  which  there  must  be  held  a  reserve-deposit 
ratio  of  R,  would  enable  the  bank  to  lend  in  addition  to  outstanding  loans: 


or 


R 

"The  deposit  arising  from  the  cash,  c,  would  itself  call  for  a  reserve  equal 
to  Re,  leaving  c  —  Re  as  reserve  for  deposits  arising  from  additional  loans" 

(P-  39)- 

If  the  reserve  ratio  be  lo  per  cent  and  the  cash  deposit  $ioo,  the  equa- 
tion would  be  solved  as  follows: 

I  $90 

—  ($100  —  $10)  or =  $900,  answer 

.10  .10 

A  distinction  is  made  between  primary  deposits  and  derivative  deposits: 
"A  primary  deposit  is  one  that  arises  from  the  actual  lodgment  in  a  bank 
of  cash  or  its  readily  convertible  equivalent,  such  as  checks  or  drafts  drawn 
on  other  banks,  but  not  made  in  anticipation  of  the  payment  of  a  loan. 
By  a  derivative  deposit  is  meant  one  which  arises  directly  from  a  loan  or 
which  is  accumulated  by  a  borrower  in  anticipation  of  the  repayment  of  a 
loan."  A  primary  deposit  is  fairly  stable;  a  derivative  deposit  is  "ex- 
tremely variable  in  magnitude."  "A  derivative  deposit  is  superimposed 
upon  the  primary  balance  and,  at  the  initial  date  of  the  relative  loan,  rises 
at  once  to  a  high  point,  falls  away  during  the  early  period  of  the  loan,  then 
as  the  loan-maturity  approaches  rises  more  or  less  gradually  co  a  peak  and, 
when  the  loan  is  paid,  drops  precipitately  to  the  initial  and  basic  level" 
(pp.  40-41). 

Dr.  Phillips  presents  the  following  formula  for  the  determination  of 
the  amount  that  any  given  uidividual  bank  in  a  system  can  add  to  its  item 
of  loans  and  discounts  on  the  basis  of  additional  reserve  deposited  with  the 
bank.    Abbreviations  are  used  for  the  following  terms; 


XX  ]  COMMERCIAL  BANK  RESERVES  287 

c    =  additional  cash  or  reserve. 

C;    =  overflow  cash,  i.e.,  what  a  bank  tends  to  lose  as 

the  result  of  making  the  additional  loans. 
.V    =  loan  expansion  resulting  from  additional  cash. 
r     =  ratio  of  cash  or  reserve  to  deposits. 
k    =  ratio  of  derivative  deposits  to  loans. 

Since  (i  —  k)  is  equal  to  the  percentage  of  loans  checked  against  by 
borrowers,  it  follows  that: 

ri  =  (/  —  k)x 

''Since  the  lending  banker  will  make  his  loans  of  such  an  amount  that 
the  cash  left  in  the  bank  after  the  overflow  cash  has  been  paid  out  will  be 
equal  to  the  reserve  required  for:  (i)  the  original  cash  deposit,  and  (2)  the 
derivative  deposits  arising  from  the  loans,  {re  +  rkx)  would  equal  the 
cash  which  the  banker  would  have  to  retain  as  reserve,  c  being  the  anwiuil 
of  the  cash  deposit  and  kx  being  the  amount  of  the  derivative  deposits,  and 
r  being  the  reserve-deposits  ratio.  If  {re  +  rkx)  is  retained  by  the  bank, 
the  amount  of  overflow  cash,  Cj,  may  be  found  by  subtracting  {re  +  krx) 
fromc.     Hence: 

Ci  =  c  —  [re  -\-  krx)  or  c  —  re  —  krx 
Since  Ci  is  also  equal  to  (/  —k)x, 

{i  —  k)  x  =  c  —  re  —  krx 
Transposing:  krx  +  (i  —  k)  x  =  c  —  re 

or  {kr  -\-i—  k)x  =  e  —  re 

and 


or 


kr  -^  I  -  k 

c  (I  -  r) 

kr  +  I  -  k 


The  above  formula  may  be  applied  to  a  concrete  case  as  follows:  cash 
equals  $1,000;  reserve-deposits  ratio  equals  10  per  cent;  and  derivative 
deposit-loan  ratio  equals  20  per  cent. 

r   =  $1,000 

r   =         .10 

k  =         .20 

1,000  (i   —  .10)        900 


.02  +  1   —  .20         .82 


or    $1,097.56 


288  BANKING  AND  CREDIT  [XX 

If  checks  drawn  by  borrowers  are  in  favor  of  depositors  of  the  drawers' 
bank,  there  will  be  no  corresponding  loss  of  cash  by  the  bank  and  to  that 
extent  the  formula  calls  for  qualification  (p.  57). 

References 

Davenport,  H.  J.     The  Economics  of  Enterprise,     pp.  260-266. 
Holdsworth,  J.  T.     Money  and  Banking. 

Changes  made  by  federal  reserve  system,  pp.  421-428. 
Phillips,  C.  A.,  Bank  Credit,     pp.  32—76. 
Westerfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  II,  pp.  387- 

399- 
Willis,  H.  P.     American  Banking,     pp.  152-176. 
— —  and  Edwards,  G.  W.     Banking  and  Business,     pp.  350-36^. 


CHAPTER   XXI 

THE   CLEARING  HOUSE 

I.  Purposes  of  a  Clearing  House. — A  bank  holds  among  its 
resources  a  number  of  items  which  represent  credit  claims  in 
process  of  settlement  and  conversion  into  cash.  Among  these 
are  to  be  noted: 

Items  with  federal  reserve  banks  in  process  of  collection. 

Exchanges  for  clearing  house. 

Checks  on  other  banks  in  the  same  place. 

Outside  checks  and  other  cash  items. 

For  the  settlement  of  many  of  these  claims  the  ingenious 
mechanism  of  a  clearing  house  is  used. 

The  operations  of  a  clearing  house  are  based  on  a  simple 
arrangement  maintained  by  an  association  of  banks  for  the  pur- 
pose of  facilitating  the  daily  exchange  of  checks  and  drafts  and 
settlement  of  balances.  In  the  development  of  this  primary 
purpose  new  ideas  have  been  gradually  added  with  the  result 
that  in  recent  years  the  clearing  house  has  possessed  efficient 
machinery  for  providing  united  action  among  the  members  in  all 
matters  affecting  their  mutual  welfare  and  in  questions  of  busi- 
ness stability  and  public  interest. 

In  the  United  States  the  use  of  a  clearing  house  for  banks  was 
first  advocated  in  183 1  by  Albert  Gallatin,  a  banker,  and  at  one 
time  Secretary  of  the  Treasury.  Some  twenty  years  later  the 
principal  New  York  banks,  recognizing  the  necessity  of  a  more 
convenient  arrangement  for  exchanging  their  checks  and  notes, 
organized  a  clearing-house  association  with  approximately  fifty 
members.  Thereafter  the  organization  of  other  clearing  houses 
in  this  country  followed  rapidly. 
19  289 


290 


BANKING  AND  CREDIT 


[XXI 


2.  Mechanism  of  a  Clearing  House. — The  most  important 
feature  of  a  clearing  house  is  the  plan  and  not  the  organization 
or  the  building  and  its  equipment.  For  the  sake  of  simplicity 
the  plan  may  be  illustrated  by  supposing  that  three  banks  have 
formed  a  clearing-house  association.  Each  day  the  clearing 
house  receives  from  bank  A  checks  drawn  on  B  and  C ;  from  B 
checks  drawn  on  A  and  C ;  and  from  C  checks  drawn  on  A  and  B. 
On  a  certain  day  A  presents  checks  on  B  for  a  total  of  $10,000 
and  on  C  $15,000;  B  presents  checks  on  A  $8,000  and  on  C 
$12,000;  C  presents  checks  on  A  $9,000  and  B  $15,000.  These 
figures  can  be  shown  in  tabular  form: 

Table  Showing  Bank  Clearings  and  Balances 


Bank 

Total  Checks  of 

Each  Bank 

Against  Other 

Banks 

Total  Checks 

by  Other  Banks 

Against  It 

Net  Balance  in 

Favor   of   Each 

Bank 

Net  Balance 

Against  Each 

Bank 

A 
B 
C 

$25,000 
20,000 
24,000 

$17,000 
25,000 
27,000 

$8,000 

$5,000 
3,000 

Totals 

$69,000 

$69,000 

$8,000 

$8,000 

\ 


It  is  evident  that  there  is  a  net  balance  of  $8,000  due  to  A 
and  net  balances  of  $5,000  and  $3,000  due  from  B  and  C.  Inas- 
much as  the  clearing  house  is  simply  a  go-between  for  the  three 
banks  and  is  not  engaged  in  a  banking  business  itself,  there 
should  be  neither  a  balance  against  it  nor  in  its  favor  at  the  end 
of  day.  According  to  the  practice  of  making  clearings,  banks  B 
and  C,  against  which  there  are  net  balances,  will  settle  first  by 
providing  the  clearing  house  with  the  necessary  funds,  or  $8,000 
in  all.  The  clearing  house  will  then  pay  A  the  net  balance  due 
it,  amounting  to  $8,000,  and  will  thus  complete  the  clearance 
operations  with  a  zero  balance,  as  is  proper. 


XXI I  THE  CLEARIXG  HOUSE  29I 

To  give  some  idea  of  the  enormous  volume  of  checks  handled 
by  clearing  houses  it  is  estimated  that  750,000  checks  pass  daily 
through  the  New  York  Clearing  House.  The  figure  for  Boston 
is  placed  at  100,000  to  200,000. 

The  clearing-house  mechanism  economizes  the  use  of  money. 
Since  the  establishment  of  the  clearing  house  in  New  York  in 
1854  there  have  been  only  two  years  in  which  over  9  per  cent  of 
the  claims  to  be  settled  had  to  be  paid  by  the  actual  transfer 
of  money,  and  in  eleven  years  the  figure  was  less  than  4  per 
cent. 

Before  the  establishment  of  the  federal  reserve  system  the 
method  of  settling  balances  varied  in  different  cities,  although 
it  was  universal  to  require  banks  which  had  balances  against 
them  at  the  clearing  house  to  make  settlement  first  and  then 
for  payment  to  be  made  by  the  clearing  house  to  the  other  banks. 
Settlements  were  made  either  on  a  cash  basis  or  on  some  other 
basis.  When  cash  was  the  basis  the  balances  were  usually  pa'd 
in  gold  coin  or  legal  tender  notes.  When  cash  was  not  the 
basis  of  settlement  there  were  a  number  of  methods  in  vogue, 
such  as: 

1.  Drafts  on  other  cities. 

2.  Clearing-house  manager's  check  on  debtor  banks  given 

to  creditor  banks. 

3.  Borrowing  and  loaning  balances  with  or  without  interest. 

4.  Clearing-house  certificates. 

5.  Clearing-house  loan  certificates. 

Of  these  dift'erent  methods  the  most  common  was  clearing- 
house certificates.  In  most  cities  each  member  of  the  clearing 
house  had  on  deposit  in  the  vaults  of  the  clearing  house,  or  some 
bank  agreed  upon  as  a  depository,  gold  coin,  silver  certificates  or 
legal  tender  notes,  for  which  clearing-house  certificates  in  large 
denominations  were  issued.  These  certificates  saved  the  actual 
handling  of  the  gold,  but  could  be  used  only  in  settling  balances 


292  BANKING  AND  CREDIT  [XXI 

between  the  members.  Another  important  advantage  in  the  use 
of  clearing-house  certificates  consists  of  the  greatly  diminished 
risk  of  transferring  funds.  In  the  case  of  a  messenger  carrying 
them  being  robbed,  no  loss  would  be  occasioned  because  they  can- 
not be  cashed  by  an  individual  and  are  good  only  for  settling  bal- 
ances between  banks.  In  times  of  financial  disturbance  or  panic, 
clearing-house  loan  certificates  were  issued  on  the  basis  of  ac- 
ceptable collateral  security  and  thus  enabled  banks  to  meet  their 
obligations  at  the  clearing  house  without  drawing  on  their  cash 
funds. 

3.  Settling  Clearing-House  Balances  under  Federal  Reserve 
System. — The  method  of  settling  clearing-house  balances  under 
the  federal  reserve  system  is  a  relatively  simple  matter.  When 
member  banks  were  required  (after  June  21,  191 7)  to  keep  their 
entire  legal  reserves  on  deposit  at  the  federal  reserve  bank  in  their 
district,  the  process  of  settling  the  net  balances  from  clearing- 
house operations  became  practically  a  matter  of  bookkeeping  by 
which  transfers  are  made  between  the  different  deposit  accounts. 
For  instance,  in  Boston  the  bank  balances  at  the  clearing  house 
are  settled  as  follows:  The  debit  banks,  all  being  members  of 
the  federal  reserve  system,  draw  their  checks  on  the  federal 
reserve  bank  to  the  order  of  the  Boston  Clearing  House,  which 
checks  are  deposited  in  the  federal  reserve  bank  to  the  credit  of 
the  manager  of  the  clearing  house.  His  checks  are  then  drawn 
in  favor  of  the  credit  banks  for  the  entire  balance,  which,  of 
course,  settles  the  business  of  the  day. 

4.  Clearings  for  Banks  Not  Members  of  the  Clearing  House. — 

Especially  in  the  larger  cities,  all  banks  do  not  find  it  advantage- 
ous to  become  members  of  the  clearing  house.  However,  this 
does  not  put  any  hardship  on  non-member  banks  for  the  reason 
that  most  of  them  clear  through  banks  (including  the  federal 
reserve  banks)  which  arc  members.     For  instance,  in  a  certain 


XXI]  THE  CLEARING  HOUSE  293 

city  the  Ninth  Trust  Company  clears  through  the  Tenth  National 
Bank.  Every  day  the  checks  which  are  received  by  the  Ninth 
Trust  Company  are  sent  to  the  Tenth  National  Bank,  which 
presents  them  together  with  its  own  items  at  the  clearing  house. 
Similarly  when  other  banks  in  the  city  receive  checks  drawn 
against  the  Ninth  Trust  Company,  they  present  them  through 
the  clearings  to  the  Tenth  National  Bank.  Thus  if  on  a  certain 
day  the  Tenth  National  Bank  sent  $45,000  of  checks  to  the  clear- 
ing house  for  the  Ninth  Trust  Company  and  received  from  the 
clearing  house  $40,000  of  checks  drawn  against  the  Ninth  Trust 
Company,  the  latter  would  have  as  a  result  of  the  day's  transac- 
tions a  favorable  balance  of  $5,000  and  this  sum  would  be  placed 
to  the  credit  of  its  deposit  account  with  the  Tenth  National  Bank. 
In  like  manner  if  the  balance  of  the  Ninth  Trust  Company 
should  be  unfavorable  by  the  same  amount,  $5,000  would  be  de- 
ducted from  the  deposit  account  which  the  Ninth  Trust  Company 
has  with  the  Tenth  National  Bank. 

In  cities  where  the  federal  reserve  bank  is  a  member  of  the 
clearing  house  it  acts  as  the  clearing  agent  for  many  banks.  In 
Boston,  for  instance,  the  federal  reserve  bank,  which  is  a  mem- 
ber of  the  local  clearing  house,  acts  as  clearing  agent  for  many  of 
the  trust  companies  which  are  not  members  of  the  clearing  house, 
or  which  do  not  clear  through  other  banks 

5.  Checks  Traded  Directly  between  Banks. — Particularly 
in  the  larger  cities  many  checks  are  exchanged  directly  between 
banks  before  and  after  the  actual  city  clearings,  which  usually 
begin  at  about  10  a.m.  and  are  finished  at  about  10:30  a.m. 
The  object  of  this  direct  exchanging  is  to  relieve  congestion  of 
work  in  the  banks  and  at  the  clearing  house.  For  purpose  of 
clearing-house  records,  however,  checks  which  are  handled  in  this 
way  are  included  in  the  totals  of  the  daily  clearings.  It  has  been 
the  custom  in  Boston  for  a  number  of  years  for  the  larger  banks  to 
meet  at  9  o'clock  and  exchange  checks.     No  settlement  is  made 


294  BANKING  AND  CREDIT  [  XXI 

at  that  hour,  but  the  totals  of  the  checks  so  exchanged  are  in- 
cluded in  the  regular  clearing  at  lo  o'clock. 

6.  Domestic  Exchange. — The  term  "domestic  exchange" 
ordinarily  refers  to  drafts  on  out-of-town  banks  located  in  the 
United  States.  Before  the  establishment  of  the  federal  reserve 
collection  system  domestic  exchange  rates  were  an  important 
factor  in  the  settlement  of  transactions  between  business  men 
in  one  section  of  the  country  and  those  in  another.  These  rates 
were  subject  to  much  the  same  influences  as  those  affecting  the 
foreign  exchanges.  For  example,  during  the  summer  and  early 
fall  funds  flow  from  east  to  west  to  finance  crop  movements. 
This  creates  an  increased  demand  in  New  York  and  other 
eastern  cities  for  drafts  on  Chicago;  or,  what  amounts  to  the  same 
thing,  there  is  an  increased  supply  of  New  York  exchange  in 
Chicago.  Consequently,  before  the  operation  of  the  federal 
reserve  system  exchange  on  Chicago  during  the  late  summer  and 
early  autumn  was  normally  at  a  premium,  while  New  York  ex- 
change in  Chicago  was  quoted  at  a  corresponding  discount. 
Naturally  the  premium  or  discount  was  small  because  it  could 
not  be  greater  than  the  cost  of  shipping  currency,  ordinarily  not 
more  than  50  cents  per  $1,000  between  Chicago  and  New  York. 

As  indicated  elsewhere,  premiums  and  discounts  on  domestic 
exchange  are  now  almost  a  thing  of  the  past  on  account  of  the 
establishment  of  the  federal  reserve  collection  system.  A  few 
banks,  particularly  in  sparsely  settled  sections,  have  not  joined 
the  system  and  obtain  revenue  by  charges  for  the  collection  of 
checks  and  drafts. 

7.  Federal  Reserve  Collection  System. — A  bank's  out-of- 
town  items  which  require  collection  include  checks  (individual 
and  bank),  drafts,  acceptances,  bonds,  and  coupons.  In  order 
to  facilitate  the  collection  of  these  items  each  federal  reserve 
bank  is  required  to  exercise  the  functions  of  a  national  clearing 


XXI]  THE  CLEARING  HOUSE  295 

house  for  its  members.  No  member  bank  is  required  to  use  it; 
and  members  may  still  keep  accounts  with  correspondents  and 
make  their  collections  through  the  latter  as  formerly.  Member 
banks,  however,  must  remit  or  receive  at  par  all  checks  drawn  on 
them  and  presented  at  their  own  counters. 

The  action  of  the  Federal  Reserve  Board  in  organizing  a 
national  clearing-house  system  caused  considerable  opposition 
to  develop,  largely  because  it  warred  against  established  customs 
in  the  matter  of  charges  for  collection  and  exchange  and  thereby 
interfered  with  an  important  source  of  profit  to  country  banks 
in  particular.  The  opposition  to  those  provisions  which  require 
the  federal  reserve  banks  to  receive  from  their  member  banks, 
at  par,  checks  and  drafts  payable  on  presentation  and  prescribe 
that  no  remittance  charge  for  such  checks  shall  be  made  against 
the  federal  reserve  banks  was  for  some  time  especially  intense 
and  sustained  in  districts  Nos.  6,  9,  and  10.  This  opposition, 
however,  has  gradually  become  less  intense  and  will,  it  is  be- 
lieved, disappear  entirely  within  a  reasonable  time  after  all  the 
banks  in  the  country  are  placed  on  the  par  list.  At  present  more 
than  95  per  cent  of  the  banks  of  the  United  States  are  on  the 
par  list. 

8.  Operation  of  System. — The  federal  reserve  collection  sys- 
tem is  thus  composed  not  only  of  member  banks,  but  also  of  all 
non-member  banks  which  have  indicated  their  willingness  to 
accept  at  par  checks  drawn  on  or  presented  to  them.  As  an  ex- 
ample of  the  operation  of  the  federal  reserve  collection  system 
let  us  consider  the  methods  used  by  the  Federal  Reserve  Bank  of 
Boston,  first  in  the  handling  of  checks,  and  second  in  the  handling 
of  other  items. 

The  Federal  Reserve  Bank  of  Boston  will  receive  from  mem- 
ber banks  checks  drawn  on  all  national  banks  in  the  United 
States,  and  such  checks  on  state  banks  and  trust  companies  as 
can  be  collected  without  payment  of  exchange.     In  order  to 


296  BANKING  AND  CREDIT  [XXI 

facilitate  collection  it  is  required  that  checks  deposited  by  mem- 
ber banks  be  sorted  into  separate  cash  letters  as  follows:  (i) 
Boston  checks,  (2)  New  England  checks,  (3)  other  district 
checks.  Checks  drawn  on  banks  and  trust  companies  located 
in  Boston  are  collected  through  the  Boston  Clearing  House  Asso- 
ciation of  which  the  federal  reserve  bank  is  a  member.  Checks 
drawn  on  banks  and  trust  companies  in  the  First  Federal  Re- 
serve District,  outside  of  Boston,  are  forwarded  direct  to  such 
banks,  which  are  required  to  remit  immediately  to  the  Federal 
Reserve  Bank  of  Boston.  Checks  drawn  on  member  and  non- 
member  banks  in  other  reserve  districts  are  dispatched  for  col- 
lection to  the  federal  reserve  bank  (or  its  branch)  in  the  district 
where  they  are  payable. 

9.  Collection  of  Time  Items. — In  addition  to  handling  checks 
for  member  banks  the  Federal  Reserve  Bank  of  Boston  will  re- 
ceive for  collection  and  credit  promissory  notes;  time,  sight,  and 
demand  drafts  with  or  without  securities,  bills  of  lading,  or  other 
documents  attached;  orders  on  savings  banks;  maturing  bonds 
and  coupons;  checks  previously  protested;  and  any  other  forms 
of  collection  items.  A  Boston  bank  is  expected  to  effect  its 
own  collection  of  time  items  payable  at  other  Boston  banks  or 
trust  companies.  United  States  coupons  are  redeemable  at  the 
federal  reserve  bank,  which  acts  as  fiscal  agent  of  the  United 
States.  There  is  no  charge  by  the  federal  reserve  bank  for  this 
collection  service  rendered  to  its  members  except:  (i)  a  charge 
of  15  cents  for  each  item  returned  unpaid,  and  (2)  any  exchange 
charge  or  fee  imposed  by  the  collecting  or  paying  agent.  In 
making  the  collection  the  federal  reserve  bank  may,  at  its  dis- 
cretion, send  any  item  direct  to  the  bank  which  is  to  make  pay- 
ment, or  where  it  is  payable,  or  it  may  send  the  item  to  an  agent 
with  like  authority  for  such  direct  sending.  The  bank  or  agent 
to  which  the  item  has  been  sent  is  then  required  to  remit 
promptly. 


XXI  ]  THE  CLEARING  HOUSE  297 

The  present  collection  system,  particularly  in  the  case 
of  checks,  has  remedied  the  three  principal  disadvantages  of 
previous  systems.     These  disadvantages  were: 

1.  In  order  to  avoid  exchange  charges  there  were  frequent 
circuitous  routings  of  checks  which  caused  delays  in  presentation 
of  checks. 

2.  Exchange  charges  were  inequitably  borne.  The  interior 
country  banks  by  charging  exchange  !or  collecting  checks  made 
large  profits,  whereas  eastern  banks  by  accepting  country  items 
at  par  made  no  profit. 

3.  Collection  of  checks  was  expensive  because  the  exchange 
charges  were  often  excessive. 

ID.  Gold  Settlement  Fund. — For  the  purpose  of  effecting 
with  as  little  delay  and  cost  as  possible  settlements  between  the 
12  federal  reserve  banks  and  their  branches  there  has  been  es- 
tablished in  the  Treasury  Department  a  gold  settlement  fund. 
By  this  means  title  to  funds  in  one  district  can  be  transferred  to 
another  without  the  actual  movement  of  money,  and  the  old 
practice  of  shifting  funds  for  crop-moving  purposes  is  abolished. 
The  heavy  movement  of  government  funds  in  connection  with 
Liberty  bonds  and  Treasury  certificates  of  indebtedness  affect  to 
a  large  extent  the  gold  settlement  fund  operations. 

Each  reserve  bank  is  required  to  keep  in  this  fund  with  the 
Treasury  of  the  United  States  a  balance  of  not  less  than  $1,000,- 
000  and  this  was  accomplished  by  shipments  of  gold  to  Washing- 
ton. The  first  withdrawal  was  made  July  14,  191 5,  when  the 
Federal  Reserve  Bank  of  Chicago  sent  a  telegram  filed  at  10.30 
A.M.  At  2.30  P.M.  the  same  day  the  Assistant  Treasurer  of  the 
United  States  at  Chicago  was  ready  to  make  payment  of 
$2,000,000  as  requested. 

The  great  value  of  this  method  of  clearings  and  transfers  is 
further  indicated  by  its  economies.  For  the  year  191 9  the  total 
expense  of  operation,  including  the  entire  cost  of  the  leased  wires 


298  BANKING  AND  CREDIT  [  XXI 

and  salaries  of  accountants,  was  approximately  $250,000.  This 
represents  the  basic  cost  of  effecting  the  domestic  changes  be- 
tween the  12  federal  reserve  districts.  The  extent  of  the  saving 
may  be  appreciated  from  the  fact  that  a  charge  of  10  cents  per 
$100,  if  generally  imposed,  would  have  involved  an  expense  to 
the  commerce  of  the  country  of  $73,984,252. 

II.  Significance  of  Cldaring-House  Figures. — For  the  pur- 
pose of  comparing  business  activity  for  different  periods  or  for 
different  sections  of  the  country,  statisticians  sometimes  employ 
clearing-house  figures.  Such  use  of  these  figures,  however,  for 
long  periods,  is  open  to  serious  criticism  unless  proper  allowance 
is  made  for  varying  conditions.  The  large  number  of  banking 
consolidations  in  recent  years  has  tended  to  make  the  number 
and  amount  of  clearing-house  items  smaller  than  what  they 
would  have  otherwise  been.  The  more  banks  there  are  in  a  com- 
munity, the  more  checks  will  be  presented  at  the  clearing  house, 
because  each  bank  will  very  likely  have  received  during  the  day 
checks  on  every  other  bank.  On  the  other  hand,  if  several  of 
these  banks  combine,  checks  that  previously  would  have  gone 
through  the  clearing  house  will  now  be  handled  by  transfer  en- 
tries on  the  books  of  the  consolidated  institution.  In  short,  if  in 
a  certain  community  it  were  possible  to  combine  all  of  the  in- 
dividual banks  into  a  single  institution  a  clearing  house  would 
not  be  necfessary. 

Notwithstanding  these  defects,  bank  clearings  are  frequently 
used  as  an  index  of  the  volume  of  business.  It  is  customary, 
however,  to  distinguish  between  the  clearings  of  banks  in  New 
York  City  and  those  in  outside  cities.  Clearings  in  New  York 
are  affected  by  stock-exchange  transactions  which  represent 
activity  in  the  field  of  speculation  rather  than  industrial  and 
commercial  enterprise.  This  may  be  illustrated  by  the  follow- 
ing table  which  shows  the  clearings  in  New  York  and  outside 
New  York  over  a  series  of  years : 


XXI  ]  THE  CLEARING  HOUSE  299 

Bank  Clearings  in  New  York  and  in  Other  Cities 


New  York  Clearings 

Outside  New  York 

Year 

Amount 

Increase  or  Decrease 

Amount 

Increase  or  Decrease 

(Billions) 

(Per  Cent) 

(Billions) 

(Per  Cent) 

1910 

$97,275 

-     6.1 

S66,82i 

+    7-3 

1911 

92,373 

-    5-0 

67,857 

+     1.6 

1912 

100,744 

+    9-1 

73,209 

+    7-9 

1913 

94,634 

-    6.1 

75,181 

+    2.7 

1914 

«3,oi9 

-  12.3 

72,227 

-    3-9 

1915 

110,564 

+  33-2 

77,253 

+    7-0 

1916 

159,581 

+  44-4 

102,275 

+  32.4 

1917 

177,405 

+  11.5 

129,540 

+  26.7 

1918 

178,533 

+    0.6 

153,821 

+  18.7 

1919 

235,803 

+  32.0 

181,717 

+  18.1 

It  will  be  observed  that  the  fluctuations  in  the  New  York 
clearings  have  been  more  violent  than  in  other  cities.  In  19 13 
and  1 914  the  number  of  shares  sold  on  the  New  York  Stock  Ex- 
change was  less  than  half  as  many  as  dealt  in  ordinarily.  Nat- 
urally the  volume  of  clearings  is  affected  by  higher  prices  and 
consequently  the  large  gains  shown  in  the  more  recent  years  are 
not  due  simply  to  the  increased  number  of  business  operations 
calling  for  payment  by  checks,  but  also  to  the  higher  prices. 

References 

Dunbar,  C.  F.     Theory  and  History  of  Banking. 

A  mathematical  explanation  of  operation,  pp.  57-58. 
Fiske,  A.  K.     The  Modern  Bank.     pp.  30-33,  76-87. 
Harris,  R.  S.     Practical  Banking,     pp.  161-177. 
Holdsworth,  J.  T.     Money  and  Banking,     pp.  212-225. 
Kniffin,W.  H.     Practical  Work  of  a  Bank.     pp.  145-163. 
Moulton,  H.  G.     Financial  Organization  of  Society,     pp.  457-468. 

Principles  of  Money  and  Banking.     Part  II,  pp.  102-115. 
Phillips,  C.  A.     Readings  in  Money  and  Banking. 

Largely  historical,  relating  to  development  in  United  States  and 
England,  pp.  355-380. 


300  BANKING  AND  CREDIT  [  XXI 

Westerfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  I,  pp.  102- 

104;  Vol.  Ill,  pp.  651-671. 
White,  H.     Money  and  Banking. 

Copy  for  a  proof  sheet,  pp.  216-223. 
Willis,  H.  P.     American  Banking,     pp.  107-132. 
and  Edwards,  G.  W.     Banking  and  Business,     pp.  236-240. 


CHAPTER  XXII 
DEFECTS    OF    THE    NATIONAL    BANKING    SYSTEM 

I.  Inelastic  Circulation. — To  understand  the  changes  which 
were  introduced  by  the  federal  reserve  banking  law  it  is  neces- 
sary to  review  some  of  the  most  salient  characteristics  of  the 
national  banking  system.  The  National  Banking  Act  of  1863 
perpetuated  the  continuance  of  local  independent  banks,  as  con- 
trasted with  a  single  large  central  bank  with  branches  or  sub- 
agencies.  These  banks  had  the  right  to  issue  circulation  secured 
by  bonds.  In  the  chapter  on  national  bank  note  circulation 
some  of  the  reasons  for  fluctuations  in  the  volume  of  these  notes 
are  given. 

Changes  in  the  volume  of  national  bank  note  currency — 
contraction  and  expansion  by  turns,  during  long  periods — did 
not  meet  the  more  sensitive  needs  of  business,  with  its  periodic 
seasonal  changes  created  by  the  movement  of  crops,  fluctuations 
in  commerce,  activity  in  the  securities  markets,  to  say  nothing  of 
the  strains  arising  during  crises.  The  currency  was  yoked  to  the 
finances  of  the  government,  as  reflected  in  the  amount  of  its  in- 
debtedness, rather  than  to  current  demands  of  industrial  and 
commercial  enterprise.  Moreover,  the  technical  regulations 
affecting  the  purchase  and  deposit  of  bonds  and  the  issue  or 
redemption  of  bank  notes  prevented  a  prompt  response  to  the 
fluctuations  of  trade.  In  this  respect  the  circulation  lacked 
elasticity. 

Elasticity  of  circulation  involves  not  only  its  possible  expan- 
sion when  there  is  demand  for  more  currency,  but  also  its  con- 
traction when  the  demand  is  over.  Contraction  is  as  necessary 
as  expansion;  otherwise  there  will  be  inflation.  Redemption  of 
notes,  resulting  in  contraction,  was  imperfect  under  the  national 

301 


302  BANKING  AND  CREDIT  [XXII 

banking  system.  A  national  bank  could  not  force  the  retirement 
of  its  notes,  except  through  the  redemption  agency  at  Washing- 
ton or  through  the  chance  presentation  of  its  notes  at  its  own 
counter.  Notes  were  rarely  sent  to  the  redemption  agency 
unless  they  were  cut  or  mutilated.  Moreover,  the  law  (1882) 
limited  the  amount  of  notes  which  could  be  withdrawn  in  any 
one  month  to  $3,000,000.'  Expansion  might  go  on  as  long  as 
bonds  could  be  purchased  and  there  was  a  profit  in  the  oper- 
ation. Contraction,  however,  was  hampered  and  could  be 
accomplished  only  with  delay. 

The  situation  was  well  described  in  a  report  of  the  National 
Monetary  Commission:^ 

The  sum  of  the  whole  matter  is  that  under  the  existing  system 
of  bank  notes  based  upon  government  bonds,  normal  and  auto- 
matic expansion  and  contraction  of  the  currency,  in  response  to 
the  ne-jds  of  trade,  is  flatly  impossible.  The  currency  supply 
may  be  greatly  enlarged  in  the  dull  midsummer  months  and  sud- 
denly contracted  when  the  active  autumn  business  season  begins. 
It  may  increase  rapidly  at  a  time  when  trade  reaction  has  reduced 
to  a  minimum  the  necessities  for  even  the  existing  bank-note 
supply,  or  it  may  be  as  rapidly  reduced  when  large  harvests,  full 
employment  of  labor,  and  active  hand-to-hand  use  of  currency 
most  need  a  larger  circulating  medium. 

Not  only  did  bank  note  currency  not  respond  to  the  needs  of 
business,  but  frequently  operated  in  the  opposite  direction. 
When  business  is  active  and  there  is  general  prosperity  the  price 
of  bonds  is  likely  to  be  high,  thus  retarding  the  increase  in  circu- 
lation. On  the  other  hand,  in  a  period  of  depression  the  price 
of  bonds  may  decline,  making  it  advantageous  to  the  banks  to 
purchase  and  thereby  enlarge  their  note  issues. 

2.  Scattering  of  the  Reserves. — In  the  chapter  on  cash  hold- 
ings and  reserve  of  a  commercial  bank  it  was  seen  that  under  the 

'  In  1907  this  was  increased  to  So, 000,000. 

^  Alexander  D.  Noyes,  History  of  the  National-Bank  Currency,  published  by  the 
National  Monetary  Commission  (1910),  p.  20. 


XXII  ]    DEFECTS  OF  THE  NATIONAL  BANKING  SYSTEM         303 

original  banking  act  reserves  were  scattered;  a  part  of  the  re- 
serves were  held  in  the  bank's  own  vault  and  a  part,  except  for 
banks  in  central  reserve  cities— New  York,  Chicago,  and  St. 
Louis — could  be  redeposited  with  agency  banks  in  reserve  cities 
or  central  reserve  cities.  A  part  of  the  reserve  might  thus  be 
massed  to  a  certain  extent,  but  this  massing  or  accumulation  of 
reserves  in  centralized  funds  was  not  directed  by  the  needs  of 
commerce. 

A  very  considerable  amount  was  attracted  to  the  banks 
in  the  central  reserve  city.  New  York,  where  it  found  ready 
use  in  loans  made  to  stock-brokers.  As  reserves  held  by 
banks  for  other  banks  were  demand  deposits,  the  New  York 
reserve  agents  who  handled  these  funds  were  obliged  to  be 
in  a  position  to  respond  promptly  to  withdrawals  by  their 
chent  depositing  banks.  They  therefore  were  disposed  to 
loan  on  call,  thus  subjecting  the  stock-brokerage  business  to 
rapid  and  violent  fluctuations  in  interest  rates.  In  March, 
191 4,  the  New  York  banks  held  $836  million  of  the  funds  of 
outside  banks,  and  an  inquiry  made  in  191 2  showed  that 
loans  to  stock-brokerage  banks  at  that  time  amounted  to  $240 
million. 

3.  Immobility  of  Reserves.— Not  only  were  the  reserves 
scattered,  although  accompanied  by  a  certain  degree  of  central- 
ization in  New  York  where  they  were  devoted  to  a  specialized 
business  relating  to  the  marketing  of  securities  rather  than  the 
support  of  commercial  undertakings,  but  they  were  rigid,  or 
immobile.  There  was  no  authority  or  machinery  whereby  they 
could  be  promptly  directed  to  reUef  when  there  was  a  special 
tension  and  demand  for  loans.  In  times  of  emergency  it  was 
difficult  to  call  home  the  reserves  which  had  been  redeposited, 
without  seriously  affecting  the  value  of  the  securities  dealt  in  on 
the  principal  stock  exchanges.  Apart  from  the  effects  upon 
stock  speculation,  a  sudden  decline  in  the  value  of  securities  may 


304  BANKING  AND  CREDIT  1  XXII 

be  disastrous,  for  these  are  used  as  collateral  in  borrowing  by 
merchants  and  manufacturers.-^ 
A  banker  (Warburg)  wrote: 

If  after  a  prolonged  drought  a  thunderstorm  threatens,  what 
would  be  the  consequence  if  the  w:ise  mayor  of  a  town  should  at- 
tempt to  meet  the  danger  of  fire  by  distributing  the  available 
water,  giving  each  house  owner  one  pailful?  When  the  lightning 
strikes,  the  unfortunate  householder  will  in  vain  fight  the  fire 
with  his  one  pailful  of  water,  while  the  other  citizens  will  all  fran- 
tically hold  on  to  their  own  little  supply,  their  only  defense  in  the 
face  of  danger.  The  fire  will  spread  and  resistance  will  be  impos- 
sible. If,  however,  instead  of  uselessly  dividing  the  water,  it  had 
remained  concentrated  in  one  reservoir  v^'ith  an  effective  system 
of  pipes  to  direct  it  where  it  was  wanted  for  short,  energetic,  and 
efficient  use,  the  town  would  have  been  safe. 

We  have  parallel  conditions  in  our  currency  system,  but, 
ridiculous  as  these  may  appear,  our  true  condition  is  even  more 
preposterous.  For  not  only  is  the  water  uselessly  distributed  into 
21,000  pails,  but  we  are  permitted  to  use  the  water  only  in  small 
portions  at  a  time,  in  proportion  as  the  house  burns  down.  If  the 
structure  consists  of  four  floors,  we  must  keep  one-fourth  of  the 
contents  of  our  pail  for  each  floor.  We  must  not  try  to  extinguish 
the  fire  by  freely  using  the  water  in  the  beginning.  That  would 
not  be  fair  to  the  other  floors.  Let  the  fire  spread  and  give  each 
part  of  the  house,  as  it  burns,  its  equal  and  insufficient  proportion 
of  water.     Pereat  mundus,  fat  justitia .'  * 

And  Kemmerer  illustrates  the  situation  as  "analogous  to 
what  would  happen  today  if  after  drilling  our  American  army  to 
a  high  point  of  fighting  efficiency,  we  should  scatter  the  men  in 
small  units  all  over  the  United  States  to  protect  the  country 
from  a  threatened  invasion.  Each  community  would  be  jealous 
of  its  own  squad  of  soldiers,  but  the  invader  would  come  and  the 
efficiency  of  our  well  drilled  soldiers  would  be  practically  nil."s 


3  See  page  188. 

*  The  Discount  System  in  Europe,  published  by  \ationaI  Monetary  Commission(i9io), 
p.  33- 

s  E.  W.  Kemmerer,  The  A  B  C  of  the  Federal  Reserve  System,  p.  6. 


XXII 1    DEFECTS  OF  THE  NATIONAL  BANKING  SYSTEM        305 

4.  Acceptance  Market  Not  Developed. — In  other  respects 
also  the  National  Banking  Act  did  not  adequately  meet  the  needs 
of  business  in  the  course  of  its  rapid  development.  No  authority 
was  given  banks  to  accept  domestic  bills  of  exchange  drawn  by 
merchants,  manufacturers,  and  others,  for  purchasing,  carrying, 
and  marketing  goods.  In  the  older  countries  of  Europe  a  bank 
not  only  makes  loans  and  discounts,  but  it  undertakes  to  accept 
bills  which  may  be  drawn  upon  it,  thus  powerfully  reinforcing  its 
credit  facilities.  This  practice  was  not  recognized  in  the  National 
Banking  Act.  There  was  fear  that  the  privilege  would  be  abused 
and  would  result  in  unsound  banking;  and,  moreover,  there  was 
not  the  apparent  need  for  this  privilege,  owing  to  the  simpler 
methods  of  business  in  this  country.  With  the  development  of 
foreign  trade  the  advantage  of  acceptances  became  more  and 
more  apparent. 

5.  Lack  of  Rediscount  Market. — Nor  was  there  a  rediscount 
market  in  the  United  States.  By  rediscounting,  commercial 
paper  which  is  held  by  one  bank  is  sold  to  another  bank.  The 
National  Banking  Act  did  not  prohibit  this  practice,  but  there 
was  a  general  prejudice  against  it.  The  discounting  of  a  note  by 
a  bank  for  its  customer  was  regarded  as  a  private  arrangement, 
the  knowledge  of  which  should  not  extend  to  another  bank.  A 
business  man  who  had  credit  could  borrow  from  his  individual 
bank,  if  the  bank  was  able  and  wilHng  to  make  loans,  but  the 
purchase  of  credit  was  to  that  extent  restricted  and  personal. 
As  a  rule  the  borrower  does  not  scatter  his  purchases  of  credit; 
his  relationship  in  this  respect  is  like  that  of  a  patient  to  his 
physician.  It  is  intimate,  confidential,  and  personal.  Unless 
this  personal  relationship  of  credit  can  be  supplemented  by  other 
devices,  there  will  be  great  variations  in  the  price  of  credit  or 
rates  of  interest  in  different  parts  of  the  country,  and  indeed  in 
different  cities  in  the  same  section.  This  immobility  of  credit 
may  be  illustrated  by  comparing  the  factors  which  determine  the 


'306  BANKING  AND  CREDIT  [  XXII 

price  of  wheat  with  those  which  determine  the  price  of  money,  the 
rate  of  interest.  Wheat  is  grown  on  thousands  of  farms  in  widely 
different  sections;  there  is,  however,  barring  the  differences  due 
to  the  cost  of  transportation,  but  one  price  for  wheat  throughout 
the  country.  In  other  words,  wheat  can  be  mobilized  and 
directed  to  any  point  where  there  is  a  deficiency.  From  the 
farm  it  goes  to  elevators  along  the  lines  of  railroads;  from  there  it 
is  accumulated  in  terminal  elevators  and  again  redistributed  to 
localities  where  demand  is  effective.  The  scattered  supply  is 
thus  distributed  and  equalized  in  accordance  with  demand 
arising  from  thousands  of  scattered  localities. 

But  it  is  far  different  in  the  buying  and  selling  of  short-term 
credit,  where  a  system  of  individualistic,  independent  banking  is 
in  operation.  There  may  be  a  large  amount  of  available  credit 
in  one  section  and  a  great  demand  in  another  which  cannot  easily 
be  supplied.  Some  method  must,  therefore,  be  devised  to 
mobilize  credit,  adjust  supply  to  demand,  and  secure  more  uni- 
form rates  of  interest.  Until  the  estabhshment  of  the  federal 
reserve  system  little  had  been  done  in  this  direction.  It  was 
looked  upon  as  a  source  of  weakness  on  the  part  of  a  bank  to 
apply  to  another  bank  for  rediscount.  Consequently  the  carry- 
ing of  loans  was  not  shifted  from  one  bank  to  another.  Banks 
in  one  section  might  hold  large  amounts  of  idle  cash,  while  those 
elsewhere  could  not  satisfy  all  the  legitimate  demand  for  com- 
mercial loans.     Potential  use  of  credit  was  thus  wasted. 

6.  Disregard  of  Banking  Defects. — There  were  thus  three 
outstanding  defects  in  the  national  banking  system:  (i)  the 
scattering  of  the  reserves;  (2)  the  inelasticity  of  bank  note  circu- 
lation; and  (3)  the  lack  of  a  well-developed  discount  market. 
Little  heed,  however,  was  given  to  these  shortcomings.  Since 
the  Civil  War  expert  attention  and  effort  had  been  largely  di- 
rected to  the  establishment  of  a  system  of  sound  currency,  by 
which  all  kinds  of  money  should  be  maintained  at  a  parity  with 


XXII 1    DEFECTS  OF  THE  NATIONAL  BANKING  SYSTEM         307 

gold.  During  the  earlier  part  of  this  period  the  problem  centered 
in  the  resumption  of  specie  payments,  by  making  government 
paper  money,  or  greenbacks,  equivalent  to  gold  in  current  pay- 
ments; later  discussion  and  legislation  was  devoted  to  the  place 
of  silver  in  the  monetary  system.  The  greenback  question  was 
settled  by  the  Resumption  Act  of  1875  and  its  fulfilment  in  1879; 
the  silver  issue  was  settled  by  the  Gold  Standard  Act  of  1900, 
whereby  provision  was  made  for  the  enlargement  and  mainte- 
nance of  the  underlying  gold  reserve  of  the  Treasury.  Engrossed 
by  these  efforts,  the  public  gave  little  attention  to  the  need  of 
banking  reform  and  changes  in  the  use  of  credit.  There  was  an 
occasional  note  of  warning  and  various  plans  were  suggested 
by  students  of  banking  and  business  organization.  None  of 
these,  however,  seriously  attracted  the  attention  of  Congress. 

7.  Panic  of  1907  and  Demand  for  Reform. — The  defects  of 
the  banking  system  were  re-emphasized  by  the  panic  of  1907. 
This,  like  all  panics,  came  unexpectedly,  and  the  disaster  which 
followed  awakened  the  public  and  Congress  to  the  necessity  of 
preventive  and  remedial  measures.  The  National  Monetary 
Commission,  under  the  chairmanship  of  Senator  Aldrich,  was 
appointed  to  collect  evidence  and  make  a  report. 

For  immediate  needs  the  Aldrich-Vrecland  law  was  enacted 
(May  30,  1908).  This  provided  for  the  issue  of  credit  notes  by 
individual  banks  upon  deposit  of  other  than  government  bonds, 
or  through  national  currency  associations  upon  pledge  of  com- 
mercial paper  to  be  taxed  at  increasing  rates  depending  upon  the 
length  of  maturity  of  the  paper. 

The  Monetary  Commission  made  an  exhaustive  investigation 
and  submitted  its  report  in  191 2.  Seventeen  defects  in  the 
existing  banking  system  were  noted.  The  chief  among  them  were 
as  follows : 

I.  There  was  no  provision  for  the  mobilization  and  use  of 
the  scattered  reserves  of  the  banks. 


308  BANKING  AND  CREDIT  I  XXII 

2.  Restrictions  were  placed  upon  use  of  reserves  so  that  they 

could  not  be  freely  employed  for  loans  in  times  of 
emergency. 

3.  The  currency  was  inelastic. 

4.  Banks  were  without  power  to  co-operate  in  times  of  stress. 

5.  Because  of  a  lack  of  a  broad  established  market  for 

agricultural,  industrial,  and  commercial  paper,  there 
was  congestion  of  loanable  funds  in  great  centers;  this 
encouraged  speculation. 

6.  There  was  lack  of  credit  facilities  in  different  parts  of 

the  country. 

The  commission  also  prepared  a  plan  for  a  central  reserve  in- 
stitution with  extensive  powers.  But  public  sentiment  was  not 
prepared  for  so  radical  a  change.  The  tradition  of  the  misdeeds 
of  the  Second  United  States  Bank  was  still  current,  there  was 
an  increasing  fear  of  a  money  trust,  the  thousands  of  independent 
banks  were  suspicious  of  any  additional  supervising  control,  and 
partisan  politics  delayed  reform. 

In  1 91 3  the  Democratic  party  came  into  power  and,  accord- 
ing to  the  position  set  forth  in  its  campaign  platform,  promptly 
undertook  the  enactment  of  legislation.  It,  however,  was  tradi- 
tionally opposed  to  centralizing  power  in  the  hands  of  the 
banks.  And  yet  no  step  in  advance  could  be  made  without 
some  degree  of  centralization.  A  compromise  was  therefore 
effected;  the  findings  of  the  Monetary  Commission  were  revised 
and  the  Federal  Reserve  Act  passed  in  19 13.  The  following 
chapter  will  describe  its  principal  provisions. 

References 

Agger,  E.  E.     Organized  Banking,     pp.  215-240. 
Holdsworth,  J.  T.     Money  and  Banking,     pp.  344-374. 
Johnson,  J.  F.     Money  and  Currency,     pp.  368-374. 
Moulton,  H.  O.     Financial  Organization  of  Society,     pp.  566-572. 
Phillips,  C.  A.    Readings  in  Money  and  Banking,    pp.  672-722. 
White,  H.     Money  and  Banking,     pp.  401-410. 


CHAPTER   XXIII 
ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM^ 

I.  Federal  Reserve  Districts.  The  Federal  Reserve  Act  pro- 
vided for  the  establishment  of  not  less  than  8  nor  more  than  1 2 
federal  reserve  banks  in  as  many  districts,  bound  together  by 
an  ingenious  mechanism  under  the  supervision  of  a  Federal 
Reserve  Board.  This  board  is  composed  of  seven  members,  five 
appointed  by  the  President  for  terms  of  ten  years  each,  and  two, 
the  Secretary  of  the  Treasury  and  the  Comptroller  of  the  Cur- 
rency, serving  ex  officio.  Two  of  the  five  members  appointed 
by  the  President  must  be  "experienced  in  banking  or  fmance." 

The  districts  were  to  be  "apportioned  with  due  regard  to  the 
convenience  and  customary  course  of  business."  As  the  act, 
however,  contemplated  that  the  capital  of  these  district  banks 
be  furnished  by  the  member  banks  within  the  respective  districts 
in  proportion  to  their  own  individual  capital,  and  as  banks  were 
not  uniformly  distributed  throughout  the  country,  the  problem 
of  districting  was  by  no  means  easy.  The  Organization  Com- 
mittee finally  agreed  upon  1 2  districts  with  federal  reserve  banks 
located  at:  (i)  Boston,  (2)  New  York,  (3)  Philadelphia,  (4) 
Cleveland,  (5)  Richmond,  (6)  Atlanta,  (7)  Chicago,  (8)  St.  Louis, 
(9)  Minneapolis,  (10)  Kansas  City,  Missouri,  (11)  Dallas,  and 
(12)  San  Francisco.  The  districts  in  which  these  banks  are 
located  are  indicated  in  the  accompanying  map  (Form  1 7) . 

In  order  to  remedy  inconveniences  arising  from  the  creation  of 
a  district  too  large  to  be  efficiently  managed,  a  federal  reserve 
bank  may  be  required  by  the  Federal  Reserve  Board  to  establish 


'  For  the  sake  of  clearness,  only  the  more  salient  features  of  the  Federal  Reserve  Act 
are  described  in  this  chapter.  Chapter  XXIV  presents  additional  data  which  enable  the 
reader  to  understand  more  adequately  the  significant  characteristics  of  this  new  legislation. 


310 


BANKING  AND  CREDIT 


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XXIIl]  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM         51I 

branch  offices  within  its  district  to  be  operated  by  boards  of 
directors  selected  by  the  Federal  Reserve  Board  and  the  federal 
reserve  bank  (Section  3).  In  1920,  22  branches  had  been  au- 
thorized. The  principal  services  which  these  branches  render 
are  in  expediting  the  receipt  and  shipment  of  currency  and  in  the 
collection  of  checks  and  maturing  notes,  thus  saving  time  in 
transportation  in  districts  of  wide  area.  All  national  banks, 
under  penalty  of  forfeiture  of  charter,  were  obHged  to  assent  to 
the  provisions  of  the  act  and  were  thus  forced  to  become  member 
banks. 

2.  Capital. — The  law  requires  that  each  federal  reserve  bank 
shall  have  a  minimum  capital  of  $4,000,000,  subscribed  in  gold 
or  gold  certificates  by  the  member  banks  (though  provision  is 
made  for  public  subscription  if  not  taken  by  banks)  at  the  rate 
of  6  per  cent  of  the  capital  and  surplus  of  each  member  bank. 
Only  half  of  this,  however,  is  immediately  payable,  the  remainder 
being  subject  to  call  by  the  Federal  Reserve  Board.  Complete 
payment  has  not  yet  been  enforced.  In  1920  the  paid-in  capital 
of  the  several  banks  was  as  follows : 

Boston $  7,718,000 

New  York 26,376,000 

Philadelphia 8,485,000 

Cleveland 10,654,000 

Richmond 5,269,000 

Atlanta 4,053,000 

Chicago 13,913,000 

St.  Louis 4,364,000 

Minneapolis 3,457,000 

Kansas  City 4,456,000 

Dallas 4,098,000 

San  Francisco 6,927,000 

Total $99,770,000 

It  will  be  observed  that  there  is  a  great  inequality  in  the  size 
of  the  banks,  the  New  York  bank  having  more  than  one-fourth 


312  BANKING  AND  CREDIT  [XXIII 

of  the  total  capitalization.  As  all  the  banks  are  under  the  super- 
vision of  the  Federal  Reserve  Board,  and  must,  if  directed,  co- 
operate as  a  unit,  this  inequality  does  not  mean  that  one  bank 
can  dominate  the  others. 

3.  Management. — Each  federal  reserve  bank  is  managed  by 
nine  directors  divided  into  three  classes  of  three  each,  known  as 
classes  A,  B,  and  C.  The  directors  in  class  A  are  chosen  by  and 
are  representative  of  the  member  banks;  the  directors  in  class  B, 
chosen  also  by  the  member  banks,  must  be  ''actively  engaged 
within  their  district  in  commerce,  agriculture  or  some  industrial 
pursuit"  (Section  4) ;  the  directors  in  class  C  are  selected  by  the 
Federal  Reserve  Board. 

The  object  of  this  classification  is  to  secure  a  variety  of  in- 
terests in  the  management.  Directors  in  class  A  represent  the 
banks;  those  in  class  B,  the  public;  and  those  in  class  C,  the 
Federal  Reserve  Board.  In  order  to  protect  the  integrity  of  the 
management  from  partizan  influences  or  the  banker's  prejudice, 
the  law  bars  any  member  of  Congress  from  appointment,  or  any 
officer  or  employee  of  any  bank  from  serving  in  classes  B  and  C. 
As  a  further  safeguard,  the  Federal  Reserve  Board  has  advised 
(December  27,  1915)  that  no  person  holding  political  or  public 
office  or  acting  as  a  member  of  a  political  party  committee  shall 
serve  as  a  director  or  officer  of  a  federal  reserve  bank. 

To  guard  still  further  against  the  domination  of  big  banks  in 
the  election  of  directors  in  classes  A  and  B  by  the  member  banks, 
the  institutions  within  each  district  are  divided  into  three 
classes,  banks  in  each  class  being  as  nearly  as  may  be  of  similar 
capitalization.  The  smaller  banks  are  in  one  group,  the  middle- 
sized  banks  in  another,  and  the  bigger  banks  in  another.  Each 
group  elects  one  director  for  class  A  and  one  for  class  B.  By  this 
device  it  was  intended  to  give  the  small  banks  an  influence 
equal  to  that  of  large  banks  in  the  management.  As  Kemmerer 
states  it: 


XXIII]  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM         313 

The  control  of  a  federal  reserve  bank  is  as  democratic  as  our 
democracy  itself.  "One  bank,  one  vote"  is  the  rule,  and  the  vote 
of  the  First  Bank  of  Jacksonville  with  its  $25,000  capital  counts 
as  much  as  that  of  the  National  City  Bank  of  New  York  with  a 
capital  and  surplus  2,880  times  as  large.  ^ 

One  of  the  directors  in  class  C,  selected  by  the  Federal  Re- 
serve Board,  is  designated  by  the  board  as  chairman  and  as 
"Federal  Reserve  Agent."  He  must  be  a  person  of  "tested 
banking  experience." 

As  an  adjunct  to  the  administration  of  the  federal  reserve 
system  is  the  Federal  Advisory  Council.  The  members  of  this 
council  are  chosen  by  the  several  federal  reserve  banks,  one 
for  each  district.  The  council  has  power  to  confer  with  the 
Federal  Reserve  Board  on  general  business  conditions  and  to 
make  recommendations  in  regard  to  discount  rates,  note  issues, 
reserve  conditions,  and  other  questions  affecting  the  reserve 
system.  Through  this  agency  it  is  expected  that  there  may  be  a 
free  opportunity  to  submit  criticism  and  to  propose  amendments. 

4.  Discounting  Functions. — The  chief  powers  of  these  federal 
reserve  banks  are  to  discount  the  notes,  drafts,  and  bills  of  ex- 
change of  member  banks;  in  other  words,  to  advance  credit  to 
them  upon  the  pledge  of  satisfactory  security;  to  issue  federal 
reserve  notes;  to  receive  deposits  from  member  banks  and  the 
United  States  government;  to  purchase  and  sell  in  the  open 
market  bankers'  acceptances;  to  deal  in  gold  coin  and  bullion;  to 
deal  in  government  securities,  including  those  of  municipalities; 
and  to  establish  foreign  agencies  and  correspondents.  The  ob- 
ject of  these  provisions  is  to  provide  a  discount  market,  nation- 
wide in  its  scope,  whereby  the  use  of  credit  may  be  made  more 
flexible.  In  addition,  national  banks  were  given  wider  powers, 
among  which  is  the  right  to  accept  bills  of  exchange  arising  out 
of  certain  commercial  transactions. 


^  E.  W.  Kemmerer,  The  A  B  C  of  the  Federal  Reserve  System,  p.  31. 


314  BANKING  AND  CREDIT  [XXIII 

The  federal  reserve  banks  widen  the  commercial  credit 
market  in  three  ways : 

1.  By  rediscounting  for  member  banks,  thus  enabling  these 

institutions  to  increase  their  own  loaning  facilities. 

2.  By  open-market  operations  in  the  purchase  and  sale  of 

acceptances,  thus  giving  encouragement  to  a  process 
of  credit  settlement,  not  as  yet  common  in  the  United 
States. 

3.  By  direct  loans  to  member  banks. 

A  federal  reserve  bank  may  discount  for  any  of  its  member 
banks  any  note,  draft,  or  bill  of  exchange,  provided: 

1 .  It  has  a  maturity  at  the  time  of  discount  of  not  more  than 
90  days,  exclusive  of  days  of  grace;  but  if  drawn  or  issued  for 
agricultural  purposes  or  based  on  hvestock  it  may  have  a 
maturity  of  not  more  than  6  months. 

2.  It  arose  out  of  actual  commercial  transactions;  that  is,  it 
must  be  a  note,  draft,  or  bill  of  exchange  which  has  been  issued 
or  drawn  for  agricultural,  industrial,  or  commercial  purposes,  or 
the  proceeds  of  which  have  been  used  or  are  to  be  used  for  such 
purposes. 

3.  It  was  not  issued  for  carrying  on  trading  in  stocks,  bonds, 
or  other  investment  securities,  except  bonds  and  notes  of  the 
government  of  the  United  States. 

4.  The  aggregate  of  notes,  drafts,  and  bills  bearing  the  signa- 
ture or  indorsement  of  any  one  borrower  rediscounted  for  any 
one  member  bank  shall  at  no  time  exceed  10  per  cent  of  the  un- 
impaired capital  and  surplus  of  such  bank;  but  this  restriction 
shall  not  apply  to  the  discount  of  bills  of  exchange,  drawn  in  good 
faith  against  actually  existing  values. 

5.  It  is  indorsed  by  a  member  bank.^ 

The  object  of  these  statutory  provisions  regulating  redis- 
count are  with  one  exception — discounts  on  securities  of   the 


3  See  Federal  Reserve  Regulations,  issued  October,  1920. 


XXIII]  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM         315 

government  of  the  United  States — to  limit  the  privilege  to  opera- 
tions connected  with  the  process  of  immediate  production,  manu- 
facture, and  marketing  of  goods.  With  this  in  view  the  Federal 
Reserve  Board  carefully  defines  the  various  kinds  of  commercial 
paper,  including:  (i)  promissory  notes,  (2)  bills  of  exchange  and 
trade  acceptances,  and  (3)  6  months'  agricultural  paper;  and  for 
these  different  classes  of  paper  each  federal  reserve  bank  deter- 
mines the  rates  of  discount  it  will  charge. 

A  federal  reserve  bank  may  also  discount  for  a  member  bank 
bankers'  acceptances  indorsed  by  at  least  one  member  bank  and 
running  for  not  more  than  90  days,  providing  they  grow  out  of 
transactions  concerned  with  the  importation  and  exportation  of 
goods,  or  provichng  they  grow  out  of  the  domestic  shipment  of 
goods,  and  shipping  documents  are  attached.  Of  like  purpose 
is  the  grant  of  power  to  purchase  bills  drawn  by  foreign  bankers 
on  member  banks  for  the  purpose  of  furnishing  dollar  exchange. 

5.  Control  of  Rediscounts. — It  is  not  designed  that  a  central 
rediscount  bank,  such  as  the  federal  reserve  banks,  shall  furnish 
an  inexhaustible  supply  of  credits  to  member  banks.  Its  primary 
purpose  is  to  provide  a  fund  from  which  individual  or  member 
banks  can  obtain  loans  in  times  of  emergency.  To  make  this 
principle  effective,  it  is  expected  that  the  central  reserve  bank 
will  charge  a  rate  higher  than  the  ordinary  average  rate  charged 
by  member  banks  to  their  customers. 

In  order  to  check  an  excessive  amount  of  credit  advances, 
either  by  member  banks  to  their  indi\ddual  clients,  or  by  federal 
reserve  banks  to  the  member  banks  which  may  seek  support 
through  the  privilege  of  rediscounts,  it  is  presumed  that  the  dis- 
trict banks  will,  if  applications  for  rediscounts  appear  to  be  based 
upon  speculation  or  unsound  business  conditions,  increase  their 
discount  rates.  The  member  banks  consequently  will  have  to 
pay  a  higher  rate  of  interest  for  their  rediscounts;  and  they  in 
turn  will  be  obliged  to  charge  their  customers  higher  rates.     In 


3l6  BANKING  AND  CREDIT  [  XXIII 

this  way  it  is  expected  that  the  federal  reserve  banks  will  be 
able  to  exert  an  effective  control  over  the  discount  market  of  the 
whole  country. 

The  operation  of  this  principle  in  its  most  rigid  form  is  well 
illustrated  in  England.  The  Bank  of  England  fixes  a  rate  of 
discount  which  it  will  charge,  higher  than  the  market  rate. 
Naturally  no  banking  institution  will  seek  credit  relief  when  com- 
pelled to  pay  a  higher  rate  than  it  charges  its  own  customers. 
By  this  action  notice  is  given  to  the  other  banks  that  if  they 
apply  for  discount  it  will  be  granted  only  on  severe  terms,  and 
with  this  warning  they  generally  stiffen  their  own  rates.  By 
this  means  the  Bank  of  England  exercises  an  effective  control. 
These  objects,  of  course,  can  only  be  accomplished  in  the  United 
States  when  the  larger  part  of  the  banking  resources  of  the  coun- 
try is  brought  within  the  scope  of  the  federal  reserve  system. 
The  primary  purpose,  however,  of  the  discount  rate  of  the  re- 
serve banks  is  to  protect  the  reserve  position  of  the  banks  rather 
than  to  influence  call  and  time  rates  of  member  banks. 

It  was  impossible  to  exercise  this  principle  of  control  by  the 
federal  reserve  banks  effectively  during  the  war  on  account  of  the 
necessities  of  government  financing,  and  since  the  war  the  prin- 
ciple has  been  in  a  large  degree  inoperative.  All  banking  insti- 
tutions were  enhsted  in  placing  the  war  loans  in  the  hands  of  as 
many  persons  as  possible,  and  to  do  this  it  was  necessary  to  ex- 
tend credit  to  purchasers  on  pledge  of  the  bonds.  Terms  for 
borrowing  by  member  banks  were  made  attractive,  generally  no 
greater  than  that  of  the  bond,  so  that  the  loan  carried  itself. 
Member  banks  could  make  advances  to  their  customers  only 
on  the  assurance  that  the  federal  reserve  banks  would  discount 
notes  secured  by  their  government  obligations  on  terms  which 
would  involve  no  loss.  "War  paper"  was  discounted  by  the 
district  banks  for  the  member  banks  at  preferential  rates. 

Not  only  may  a  reserve  bank  rediscount  the  commercial 
paper  presented  by  a  member  bank,  but  it  may  loan  directly  to 


XXIII J  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM         317 

these  banks.  These  loans,  however,  must  have  very  short  ma- 
turities, not  exceeding  15  days,  and  the  promissory  note  of  the 
borrowing  bank  must  be  secured  by  commercial  paper  eligible  for 
rediscount,  or  by  government  securities. 

6.  Open-Market  Operations. — In  addition  to  the  foregoing 
dealings  with  banks,  federal  reserve  banks  may  engage  in  cer- 
tain open-market  operations,  in  the  purchase  of  bills  of  exchange, 
trade  acceptances,  and  bankers'  acceptances  of  the  kinds  and 
maturities  made  eligible  for  rediscount,  with  or  without  the  in- 
dorsement of  a  member  bank;  that  is,  a  federal  reserve  bank  may 
take  the  initiative  for  employing  its  funds  by  purchasing  in  the 
open  market  certain  kinds  of  short-term  paper  or  credits.  Until 
the  passage  of  this  act  national  banks  could  not  accept  time  bills 
and  this  power  was  conferred  upon  state  banks  in  only  a  few 
states.  The  Federal  Reserve  Act  specifically  grants  this  privi- 
lege and  thus  increases  the  use  of  the  acceptance  as  an  agency  in 
mobilizing  credit.  At  first  the  privilege  was  limited  to  credits 
advanced  for  the  importation  or  exportation  of  goods,  but  later 
it  was  extended  to  credits  for  domestic  trade.  Not  only  may 
member  banks  deal  in  acceptances  but  the  reserve  banks  can  pur- 
chase them  in  the  open  market.  In  order  to  encourage  the  de- 
velopment of  this  credit  instrument,  and  because  of  its  high 
quality,  the  federal  reserve  banks  have  at  times  granted  a  more 
favorable  rate  of  discount  on  it  than  that  given  for  ordinary 
commercial  paper. 

The  privilege  of  granting  acceptances  may,  however,  be 
abused,  for  some  banks  regard  the  acceptance  as  a  method  of  in- 
creasing their  lending  power  beyond  the  limits  imposed  by  sound 
banking  principles.  A  limit  therefore  is  set  upon  the  volume  of 
bills  which  an  individual  bank  may  accept. 

7.  Discount  Rates  of  Federal  Reserve  Banks. — The  federal 
reserve  banks  act  independently,  but  under  the  approval  of  the 


3l8  BANKING  AND  CREDIT  [XXIIl 

Federal  Reserve  Board,  in  making  their  rates  on  the  different 
classes  of  paper  which  they  discount  for  member  banks.  The 
procedure  is  illustrated  by  the  table  on  page  319,  which  shows 
rates,  by  banks  and  by  character  of  paper,  prevailing  in  March, 
1921. 

For  all  bills  discounted  in  October,  1 920,  the  average  maturity 
was  13  days.  The  New  York  reserve  bank  held  bills  with  short- 
est maturities,  7  days  on  the  average ;  while  the  bills  of  the  Minne- 
apolis and  Kansas  City  reserve  banks  ran  for  approximately 
40  days. 

8.  Holding  of  Reserves  of  Member  Banks. — Among  the 
enumerated  powers  of  the  federal  reserve  bank  is  the  right  to  re- 
ceive deposits  from  a  member  bank.  The  new  act  makes  these 
institutions  the  depositories  of  the  reserves  of  all  national  banks 
and  other  banks  joining  the  federal  reserve  system.  Hitherto 
the  reserves  of  national  banks  had  been  carried  in  their  own 
vaults,  or  in  part  held  by  banks  in  reserve  cities  and  central  re- 
serve cities.  This  resulted,  as  already  explained,  in  scattered 
reserves.  The  object  of  the  new  plan  was  to  mass  these  reserves 
so  as  to  make  them  more  effective  and  also  to  divert  their  use  into 
more  strictly  commercial  purposes.  Under  the  act  (as  amended 
June  21,  191 7),  every  member  country  bank  keeps  a  reserve  bal- 
ance with  its  federal  reserve  bank  of  7  per  cent  on  its  demand 
deposits;  a  bank  in  a  reserve  city,  of  10  per  cent;  and  a  bank  in  a 
central  reserve  city,  of  13  per  cent.  On  time  deposits  all  classes 
of  banks  maintain  a  reserve  of  3  per  cent.  Under  these  per- 
centages the  amount  of  reserve  which  must  be  held  is  less  than 
originally  prevailed.  The  combination  of  reserves  makes  their 
use  more  economical;  and,  as  individual  banks  can  obtain  funds 
by  applying  for  rediscounts,  it  is  not  necessary  to  keep  on  hand 
large  amounts  for  emergency. 

No  longer  do  the  member  banks  keep  any  reserves  in  their  own 
vaults.    The  holdings  of  actual  cash  in  their  own  vaults  is  de- 


XXIII]  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM         319 


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320  BANKING  AND  CREDIT  [  XXIII 

termined  by  individual  policy  according  to  current  needs,  but  such 
holdings  are  of  no  significance  in  the  calculation  of  legal  reserves. 

Member  banks  may  keep  as  much  or  as  little  cash  on  hand 
for  till  money  as  they  wish  to.  They  may  keep  balances  in  other 
banks  if  it  suits  their  convenience  to  do  so — all  that  is  their  own 
affair  for  which  their  responsibility  is  to  their  stockholders  and 
their  customers — but  their  legal  reserve,  the  reserve  which  the 
Government  looks  upon  as  the  minimum  below  which  the  public 
interest  demands  that  banks  should  not  go,  that  reserve  must  all 
be  kept  on  deposit  in  federal  reserve  banks,  the  nation's  reservoirs 
of  reserve  money. '' 

From  the  foregoing  provisions  it  must  not  be  assumed  that 
local  banks  throughout  the  country  have  discontinued  the  prac- 
tice of  placing  a  part  of  their  funds  in  New  York  City  banks. 
Probably  half  of  the  money  loaned  on  stock  exchange  collateral 
in  New  York  is  that  of  interior  banks.  Interior  banks  still  invest 
funds  in  New  York,  but  such  funds  are  no  longer  part  of  their 
reserve. 

Under  the  present  system  the  total  reserve  to  be  maintained 
by  member  banks  is  much  lower  than  under  the  old  system. 
Assume  that  the  deposits  of  member  banks  amount  to  $io 
billion  distributed  as  follows: 

Billions 

Central  reserve  cities $t, 

Reserve  cities 3 

Country  banks 4 

The  reserves  under  the  old  system  would  be: 

Cash  in  Vaultss 
Per  Cent  (Millions) 

Central  reserve  cities 25  $750 

Reserve  cities 25  375 

Country  banks 15  240 

11,365 

•<  E.  W.  Kemmerer,  The  A  B  C  of  the  Federal  Reserve  System,  p.  36. 
5  It  is  assumed  that  banks  kept  only  the  minimum  amount  of  reserve  and  that  banks  in 
reserve  cities  and  country  banks  redeposited  their  reserves. 


XXIIT]  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM         321 

Under  the  new  system,  the  balances  to  be  held  by  the  federal 
reserve  banks,  assuming  that  all  deposits  are  on  demand,  are: 

Per  Cent  Millions 

Central  reserve  cities 13  $390 

Reserve  cities 10  300 

Country  banks 7  280 


Although  the  member  banks  are  not  required  to  hold  any  cash 
for  reserve  purposes,  they  will  necessarily  keep  some  for  current 
needs  of  depositors.  The  federal  reserve  banks,  however,  are 
obliged  to  keep  a  reserve  of  3  5  per  cent  in  cash  against  the  deposits 
of  member  banks,  or  $339.5  milhon  as  compared  with  $1,365 
million  under  the  old  system.  More  than  a  billion  dollars  is  thus 
set  free  for  credit  purposes. 

The  massing  of  the  reserves  makes  a  large  accumulation. 
The  12  federal  reserve  banks  at  the  close  of  1920  held  over  $2 
billion  in  gold  besides  nearly  $200  million  of  legal  tender  notes 
and  silver.  Their  total  reserve  was  $2,249,000,000  to  protect 
$1,748,979,000  of  member  deposits  and  $3,344,686,000  of  federal 
reserve  notes. 

9.  Reduction  of  Reserves  by  Federal  Reserve  Act. — The 

great  reduction  in  reserve  requirements  resulting  from  the 
Federal  Reserve  Act  is  conveniently  shown  in  the  following 
table : 

Example  i.  A  national  bank  in  New  York  City  (central 

reserve    city    bank)    having    total    demand 

deposits  of  $200,000,000. 
Example  2.  A  national  bank  in  Boston  (reserve  city  bank) 

having  total  demand  deposits  of  $100,000,000. 
Example  3.  A  national  bank  in  Worcester,  Mass.  (country 

bank),    having    total    demand    deposits    of 

$10,000,000. 


Reduction  in  Reserve  Requirements  under  Federal  Reserve  Act 


Item 

Previous  to  191 3 

At  Present  (1922) 

(a) 

I 
Reserve  requirements 

$50,000,000;  25% 

$26,000,000;  13% 

(b) 

Character  of  reserve . 

Lawful  money  in  bank's 
vaults 

Deposit  account  at  federal 
reserve  bank  against 
which  federal  bank  is 
required  to  keep  35%  in 
lawful  money  in  its  own 
vaults 

(c) 

Amount  of  reserve  in 

form  of 

lawful  money  back  of  each 

dollar  of  demand 

deposits 

of  national  bank  .  . 

25  cents 

4.55  cents  (.35  X  13) 

(a) 

2 

Reserve  requirements 

$25,000,000;  25% 

$10,000,000;  10% 

(b) 

Character  of  reserve . 

1/2     in     lawful     money 
in   bank's    vaults  and 
1/2*  in  deposit  account 
in  a  central  reserve  city 
bank     (New     York, 
Chicago,  or  St.  Louis) 

Deposit  account  at  federal 
reserve  bank  against 
which  federal  reserve 
bank  is  required  to  keep 
35%  in  lawfu'  money  in 
its  own  vaults 

(c) 

Amount  of  reserve  in 

form  of 

15.62s   cents    (1/2   of   25 

3.5  cents  (.35   X   10) 

lawful  money  back  of  each 

cents  plus  1/4  of  12  1/2 

dollar  of  demand 

deposits 

cents) 

of  national  bank  .  . 

(a) 

3 

Reserve  requirements 

$1,500,000;  15% 

$-?00,ooo;  7% 

(b) 

Character  of  reserve. 

2/5     in    lawful    money 
in     bank's   vaults  and 
3/5*  in  deposit  account 
in  a  central  reserve  city 
or  reserve  city  bank 

Deposit  account  at  federal 
reserve  bank  against 
w  hich  federal  reserve 
bank  is  required  to  keep 
35%  in  lawful  money  in 
its  own  vaults 

(c) 

Amount  of  reserve  in 

form  of 

8.2s  cents  (2/5  of  15  cents 

2.45  cents  (.35   X  7) 

lawful  money  back  of  each 

plus   1/4  of  3/5   of   15 

dollar  of  demand 

deposits 

cents) 

of  national  bank  .  . 

*  option  of  bank  which  was  permitted  to  keep  whole  reserve  in  its  own  vaults. 

Note:  In  the  above  tabulation  no  mention  is  made  of  time  deposits,  which  are  relatively 
unimportant  as  compared  with  demand  deposits.  Previous  to  1913  no  distinction  was  made 
betw  een  demand  deposits  and  time  deposits  in  so  far  as  reserve  requirements  were  concerned. 
At  present  the  reserve  requirement  for  time  deposits  is  3  per  cent.  The  fact  that  vault  cash 
was  formerly  counted  as  a  part  of  the  required  reserves,  whereas  under  the  Federal  Reserve 
Act  it  is  not  permitted  to  be  so  counted,  is  taken  into  account. 

322 


XXIII  ]  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM         3^3 

10.  Interbank  Rediscounts.— But  the  reserve  protection  is 
stronger  than  would  appear  from  the  creation  of  twelve  large 
funds.  Machinery  is  devised  whereby  these  separate  funds  can 
be  made  effective  for  mutual  support.  One  federal  reserve 
bank  may  be  called  upon  to  rediscount  commercial  paper  for 
another  federal  reserve  bank;  and  thus,  if  there  be  a  strain  in  one 
district,  rehef  can  be  given  by  federal  reserve  banks  in  other  dis- 
tricts. This  mutual  service  and  aid  may  be  voluntarily  entered 
into  by  the  federal  reserve  banks,  or  it  may  be  enforced,  at  its  dis- 
cretion, by  the  Federal  Reserve  Board.  In  accordance  with  this 
policy  rediscounting  between  the  federal  reserve  banks  has  been 
frequently  exercised.  So  far  as  possible  the  reserve  position  of 
the  several  reserve  banks  is  equalized.  In  this  way,  as  one 
writer  phrases  it:  "The  reserves  of  the  twelve  reserve  banks  are 
so  closely  piped  together  that  they  may  reasonably  be  con- 
sidered to  be  closely  connected  tanks  of  a  single  large  reservoir."^ 

11.  Note  Issue  Made  More  Elastic. — The  framers  of  the 
Federal  Reserve  Act  determined  that,  in  order  to  make  the  cur- 
rency more  elastic,  a  new  kind  of  bank  note  should  be  introduced. 
Elasticity  in  the  medium  of  exchange  does  not  necessarily  de- 
mand an  increase  in  bank  notes,  for  the  same  end  may  be  accom- 
pHshed  through  the  medium  of  deposit  currency  and  the  transfer 
of  bank  book  credits.  The  analysis  of  banking  operations  shows 
that  credit  may  be  extended  to  a  borrower  either  by  the  creation 
and  transfer  of  a  promissory  note  as  a  bank  note,  or  by  giving 
him  a  deposit  account  against  which  he  can  draw  checks. 

England  until  recently  has  reHed  upon  deposit  accounts 
rather  than  bank  notes  in  the  granting  of  bank  credit.  The 
United  States,  on  the  other  hand,  has  freely  used  the  issue  of  bank 


*  E.  W.  Kemmerer.  The  A  B  C  of  the  Federal  Reserve  System,  p.  41.  Interbank  bor- 
rowing on  a  small  scale  has  been  practiced  for  many  years  in  times  of  emergency,  particularly 
in  the  South  and  West.  Like  rediscounting  between  banks,  however,  it  was  regarded  as  a 
sign  of  weakness  on  the  part  of  the  borrowing  bank,  and  the  liability  was  frequently  con- 
cealed on  the  balance  sheet.  See  O.  C.  Lockhart,  "  Development  of  Interbank  Borrowing 
in  the  National  System."  Journal  of  Political  Economy,  Feb.  and  Mar.  192  i. 


324  BANKING  AND  CREDIT  |XXIII 

notes  for  the  supply  of  such  credits.  State  banks  until  the  Civil 
War  period  issued  large  amounts  of  bank  notes.  The  national 
banking  system  openly  encouraged  this  policy,  due  to  the  effort 
to  create  a  market  for  government  bonds.  Thus  through  a 
century  of  expansion  this  policy  became  ingrained  in  the  busi- 
ness habits  of  the  people.  The  credit  problems  of  an  old  and 
small  nation,  as  England,  where  business  relationships  are 
closely  knit  together  through  a  long  period  of  commercial  de- 
velopment, are  different  from  those  existing  in  a  country  as  large 
as  the  United  States,  with  widely  scattered  and  diversified 
interests  and  less  confidence  in  the  promise  of  an  individual 
as  compared  with  that  of  an  organized  banking  institution. 
Moreover,  the  use  of  bills  of  exchange  and  acceptances  had  not 
been  greatly  developed  in  the  United  States. 

It  was  not  to  be  expected,  therefore,  that  the  new  federal 
reserve  system  would  do  away  with  bank  notes  as  a  means  of 
providing  credit.  The  purpose  was  to  make  the  use  of  this  form 
of  credit  more  elastic  and  serviceable  to  the  needs  of  business. 

12.  Federal  Reserve  Notes. — The  act  provides  for  the  issue  of 
federal  reserve  notes  by  the  Federal  Reserve  Board,  to  be  ad- 
vanced to  the  federal  reserve  banks  in  exchange  for  an  equal 
amount  of  collateral  in  the  form  of  notes,  drafts,  bills  of  exchange, 
acceptances,  bankers'  acceptances,  gold  and  gold  certificates. 
It  is  thus  made  possible  for  the  federal  reserve  banks  to  redis- 
count the  offerings  of  commercial  paper  tendered  by  the  member 
banks.  If  the  volume  of  loans  made  by  member  banks  is  large 
and  the  latter  seek  rediscounts  at  the  district  banks,  and  if  these 
in  turn  require  the  aid  of  credit  from  the  Federal  Reserve  Board 
as  represented  by  the  reserve  notes,  a  large  volume  of  notes  will 
be  issued.  If  commerce  and  industry  decline,  necessitating  a 
less  demand  for  discounts,  the  volume  of  notes  will  shrink. 
When  a  business  transaction  is  closed  and  the  debtor  of  the  mem- 
ber bank  settles  this  obligation,  the  commercial  paper  underlying 


XXIII  ]  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM         325 

the  federal  reserve  notes  is  liquidated.  The  member  bank  meets 
its  obligation  to  the  federal  reserve  bank,  and  to  that  extent 
the  federal  note  circulation  is  contracted.  Reserve  bank  note 
currency  responds  to  the  needs  of  business  and  thus  has  the  qual- 
ity of  elasticity. 

Federal  reserve  notes  are  issued  not  only  against  commercial 
paper  but  also  against  gold  and  gold  certificates.  This  latter 
provision,  therefore,  does  not  increase  the  elasticity  of  the  cur- 
rency but  makes  it  possible  to  change  the  form  of  the  monetary 
medium.  For  the  success  of  the  federal  reserve  system  it  was 
beheved  necessary  that  the  gold  held  by  thousands  of  banking 
institutions  should  be  massed  and  placed  under  the  control  of  the 
federal  reserve  banks.  By  this  means  the  reserve  power  of  the 
reserve  banks  would  be  strengthened.  Not  only  did  the  member 
banks  deposit  gold  in  transferring  their  reserves  on  deposits, 
but  they  were  urged  to  exchange  any  surplus  gold  which  they 
held  for  federal  reserve  notes.  In  the  first  few  years  of  opera- 
tion, before  the  member  banks  took  advantage  of  rediscounting 
commercial  paper,  a  very  considerable  part  of  the  federal  reserve 
note  issue  was  based  upon  gold  collateral. 

While  the  notes  are  not  legal  tender,  they  are  "obligations  of 
the  United  States  and  shall  be  receivable  by  all  national  and 
member  banks  and  federal  reserve  banks  and  for  all  taxes, 
customs  and  other  public  dues."  They  are  redeemable  in  gold 
on  demand  at  the  Treasury  Department  at  Washington,  or  in 
gold  or  lawful  money  at  any  federal  reserve  bank  (Section  16). 

The  notes  of  all  federal  reserve  banks  are  of  the  same  design, 
but  the  issues  of  the  several  twelve  banks  bear  a  distinctive 
letter  and  serial  number  so  that  the  notes  issued  through  a  given 
bank  may  be  identified.  The  Federal  Reserve  Bank  in  Boston 
represents  the  First  District  and  consequently  its  notes  carry 
i-A;  New  York  is  the  Second  District  and  its  notes  are  marked 
2-B,  etc.  To  promote  redemption,  whenever  notes  issued 
through  one  federal  reserve  bank  are  received  by  another,  they 


326  BANKING  AND  CREDIT  [XXIII 

must  be  promptly  returned  for  credit  or  redemption  to  the  federal 
reserve  bank  through  which  they  were  originally  issued,  or  they 
may  be  forwarded  to  the  Treasurer  of  the  United  States  to  be  re- 
tired. Non-compHance  with  this  regulation  involves  a  penalty  of  a 
tax  of  lo  per  cent  upon  the  value  of  the  notes  if  otherwise  paid  out. 

13.  Reserves  against  Deposits  and  Notes. — We  have  now 
two  classes  of  liabilities,  outside  of  the  liability  to  member  banks 
for  their  subscribed  capital  stock.  These  are,  first,  the  liabih- 
tiesto  the  depositing  banks,  and,  second,  the  liability  for  the  note 
issues.  Ample  provision  is  made  against  these  liabilities.  Each 
federal  reserve  bank  must  maintain  a  reserve  in  gold  or  lawful 
money  of  not  less  than  35  per  cent  against  its  deposits,  and  a 
reserve  of  gold  alone  (including  gold  certificates)  of  not  less  than 
40  per  cent  against  its  federal  reserve  notes  in  actual  circulation. 
Gold,  or  gold  certificates,  which  is  received  as  collateral  for  the 
issue  of  these  notes  may  be  included  in  the  gold  reserve  against 
circulation. 

The  federal  note  issues  may  under  authority  of  the  Federal 
Reserve  Board  be  increased  beyond  the  limits  involved  in  the 
holding  of  a  40  per  cent  gold  reserve.  In  other  words,  in  case  of 
emergency  the  reserve  requirements  may  be  suspended.  In 
order,  however,  to  control  this  expansion  and  bring  it  speedily  to 
an  end  when  the  emergency  has  passed,  a  graduated  tax  is  im- 
posed upon  the  deficiency  in  the  reserve.  This  amounts  to  not 
less  than  i  per  cent  until  the  reserve  falls  to  32  1/2  per  cent,  and 
to  not  less  than  i  1/2  per  cent  upon  each  2  1/2  per  cent  the  reserve 
falls  below  32  1/2  per  cent.  This  tax  is  paid  by  the  federal  re- 
serve bank,  but  in  turn  will  be  added  to  the  rates  of  interest  and 
discount  charged  by  the  federal  reserve  bank  in  its  dealings  with 
member  banks. 

14.  Federal  Reserve  Bank  Notes. — In  addition  to  federal 
reserve  notes  the  federal  reserve  banks  issue  notes  secured  spe- 


XXIII J  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM        327 

cifically  by  United  States  bonds,  known  as  "federal  reserve  bank 
notes."  The  Federal  Reserve  Act  contemplates  the  retirement 
of  national  bank  notes  secured  by  bonds,  and  makes  provision 
for  the  taking  over  of  the  bonds  which  national  banks  own  in 
order  that  they  may  not  suffer  loss.  It  was  not  thought  wise  to 
withdraw  at  once  during  this  process  the  circulation  based  upon 
these  bonds,  and  the  federal  reserve  banks  were  given  the  same 
privilege  of  deposit  of  bonds  and  issue  of  notes  enjoyed  by  the 
national  banks.  Owing  to  the  new  loans  made  by  the  govern- 
ment and  the  burdens  placed  upon  the  federal  reserve  banks,  it 
has  not  been  possible  to  effect  the  retirement  of  these  notes  as 
originally  planned.  In  19 18  there  was  a  considerable  increase 
in  the  issue  of  this  variety  of  notes  due  to  a  requirement  in  the  act 
authorizing  the  sale  of  silver  and  retirement  of  silver  certificates 
and  the  issue  in  their  place  of  federal  reserve  bank  notes. 

15.  Membership  by  State  Institutions. — In  order  to  broaden 
the  rediscount  market  and  to  utilize  the  banking  reserves  of  the 
country  and  thus  make  the  new  system  effective  in  the  highest 
degree,  it  was  considered  desirable,  if  possible,  to  bring  state  in- 
stitutions under  the  scope  of  the  act.  The  federal  reserve  law 
provides  that  any  bank  incorporated  under  a  state  charter  may 
become  a  member  bank  under  substantially  the  same  rules  and 
regulations  to  which  a  national  bank  is  subject,  without  losing  any 
of  the  statutory  rights  it  may  possess  under  the  state  charter. 
It  must  have  the  same  amount  of  unimpaired  paid-up  capital 
which  a  national  bank  must  have,  according  to  the  place  where  it 
is  located;  must  subscribe  to  the  capital  stock  of  the  district 
banks;  must  maintain  the  reserve  requirements  of  the  reserve 
act;  must  make  reports  and  be  subject  to  examinations. 

During  the  first  two  years  of  the  operation  of  the  law  few 
state  institutions  joined  the  system.  There  was  fear  that  the 
privileges  enjoyed  under  state  charters  might  be  sacrificed,  and  the 
advantages  to  be  gained  under  the  new  act  were  not  sufficiently 


328  BANKING  AND  CREDIT  [XXIII 

clear  to  justify  a  change.  Many  of  the  state  banks  did  not  have 
the  minimum  capital  required  under  the  provisions  of  the  act; 
they  objected  to  an  increase  in  their  reserves,  for  the  require- 
ments of  state  laws  were  generally  more  liberal  than  was  demanded 
by  the  federal  act;  they  feared  that  they  would  receive  less  in- 
terest since  they  could  no  longer  deposit  a  part  of  their  reserves 
with  other  banks;  they  were  averse  to  submitting  reports  to  the 
Comptroller  of  the  Currency,  a  federal  official;  and,  in  general, 
they  were  not  willing  to  sacrifice  the  charter  powers  and  statutory 
rights  which  they  possessed  as  state  institutions.  The  privilege 
of  securing  rediscounts  was  not  regarded  as  a  great  advantage, 
for  the  banks  at  that  time  had  abundant  funds;  even  the  national 
banks  rarely  sought  rediscounts.  Moreover,  a  non-member 
bank  could  indirectly  obtain  rediscounts  through  a  member 
bank. 

A  campaign  of  education  was  directed  toward  convincing  the 
state  banks  that  they  would  lose  no  substantial  rights  and  that 
they  would  gain  by  having  the  right  to  secure  rediscounts  from  a 
federal  reserve  bank.  As  there  was  hesitation  on  the  part  of  many 
institutions  to  take  advantage  of  this  opportunity,  the  original 
law  was  amended  so  as  to  make  withdrawal  possible,  if  the  rela- 
tionship did  not  prove  satisfactory,  without  requiring  the  disso- 
lution of  the  bank.  Permission  was  given  to  retain  state  charter 
powers;  reports  were  to  be  made  to  the  federal  reserve  banks, 
instead  of  to  the  Comptroller  of  the  Currency;  and  examinations 
of  the  banks  were  also  supervised  by  a  reserve  bank  instead  of  by 
the  Comptroller. 

With  the  new  credit  demands  created  by  the  war,  the  need  of 
a  uniform  system  became  more  apparent.  Patriotic  appeals 
were  made  to  the  state  institutions  to  enter  the  system.  In 
October,  191 7,  President  Wilson  made  a  pubfic  statement,  in 
which  he  declared : 

It  is  manifestly  imperative  that  there  should  be  a  complete 
mobilization  of  the  banking  reserves  of  the  United  States.  .  .  . 


XXIII]  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM        329 

A  vigorous  prosecution  and  satisfactory  termination  of  the  war 
will  depend  in  no  small  degree  upon  the  ability  of  the  Govern- 
ment not  only  to  finance  itself,  but  also  to  aid  the  governments 
associated  with  it  in  the  war,  which  must  be  kept  supplied  with 
munitions,  fuel,  food,  and  supplies  of  all  kinds.  The  banking 
problem  involved  is  one  which  concerns  all  banks  alike.  Its 
solution  does  not  depend  upon  the  national  banks  alone,  nor 
upon  the  state  banks.  The  burden  and  the  privilege  must  be 
shared  by  eveiy  banking  institution  in  the  country. 

Influenced  by  such  appeals  and  by  legislation,  both  federal 
and  state,  which  removed  some  of  the  objections,  state  institu- 
tions have  more  recently  joined  in  larger  numbers.  Another 
factor  influenced  state  institutions:  By  an  amendment  to  the 
reserve  act  (September  26,  1918)  a  national  bank  was  given  the 
right  to  exercise  trust  powers  and  to  act  as  executor,  registrar  of 
stocks  and  bonds,  guardian  of  estates,  and  in  any  other  fiduciary 
capacity  permitted  under  the  laws  of  the  state  in  which  the 
national  bank  may  be  located,  previously  denied  to  them  and 
exclusively  enjoyed  by  trust  companies.  As  national  banks 
could  thus  compete  with  state  trust  companies,  these  advantages 
previously  enjoyed  by  the  latter  became  of  diminished  conse- 
quence. To  offset  this  loss  they  found  it  expedient  to  seek  the 
privileges  granted  by  federal  reserve  membership.  At  the  be- 
ginning of  192 1  the  membership  of  state  banks  and  trusts 
numbered  1,487,  representing  a  capital  and  surplus  of  $1,034 
million.  There  were  9,000  state  institutions  ehgible  for  member- 
ship, having  over  one-fourth  of  the  total  banking  capital  and 
surplus  in  the  United  States,  which  were  not  members.  '^ 

16.  Relation  of  Federal  Reserve  Banks  to  the  Government. 

— Although  the  federal  reserve  banks  are  not  directly  managed 
or  controlled  by  the  government,  the  relationship  of  the  govern- 
ment to  the  new  system  is  close  and  intimate.     The  supervisory 


'  See  Seventh  Annual  Report  of  the  Federal  Reserve  Board  for  1920,  p.  84. 


330  BANKING  AND  CREDIT  [  XXIII 

body,  the  Federal  Reserve  Board,  is  appointed  by  the  President 
(by  and  with  the  advice  and  consent  of  the  Senate) ;  the  Federal 
Reserve  Board  has  a  voice  in  selecting  one-third  of  the  board  of 
directors  for  each  of  the  12  district  banks;  the  federal  reserve 
notes  are  direct  obligations  of  the  United  States;  a  certain  por- 
tion of  the  excess  profits  of  the  banks  must  be  paid  to  the  govern- 
ment as  an  excess  tax,  and  the  reserve  banks  must  perform  for 
the  government  certain  fiscal  agency  operations.  On  the  other 
hand,  the  several  regional  banks  are  not  under  the  direct  control 
of  the  government,  for  each  board  of  directors  can,  subject  to 
the  supervisory  powers  of  the  Federal  Reserve  Board,  manage  its 
own  affairs.  The  chairman  of  the  directors  of  each  reserve  bank 
is,  however,  appointed  by  the  Federal  Reserve  Board. 

As  fiscal  agents  of  the  federal  government,  the  federal  re- 
serve banks  perform  important  services.  They  take  charge  of 
placing  loans  and  may  hold  government  deposits.  Formerly 
the  funds  of  the  Treasury  were  kept  in  part  in  the  sub-treasuries 
and  in  part  deposited  with  national  banks.  This  system  had 
its  disadvantages.  A  surplus  in  the  Treasury  frequently  led  to 
accumulation  of  money  in  the  sub-treasuries,  where  it  was  un- 
available for  active  service  in  business;  and  the  scattering  of 
the  deposits  among  the  national  banks  was  determined  by  ad- 
ministrative judgment,  rather  than  by  the  need  of  the  money. 
Moreover,  the  apportionment  of  government  funds  deposited 
with  national  banks  frequently  aroused  criticism  and  jealousy  on 
the  part  of  the  banks. 

The  reserve  act  provides  that  "the  moneys  held  in  the  general 
fund  of  the  treasury,  except  the  five  per  centum  fund  for  the  re- 
demption of  outstanding  national  bank  notes,  and  the  funds 
provided  in  this  act  for  the  redemption  of  federal  reserve  notes, 
may,  upon  the  direction  of  the  Secretary  of  the  Treasury  be  de- 
posited in  federal  reserve  banks"  (Section  15)..  Few  transfers 
of  government  funds  from  national  banks  to  reserve  banks  were 
made  during  the  early  years  of  the  system,  owing  to  the  disin- 


XXIII]  ORGANIZATION  OF  FEDERAL  RESERVE  SYSTEM         331 

clination  to  disturb  established  relationships.  Later,  on  account 
of  the  huge  financial  undertakings  of  the  government  occasioned 
by  the  war,  it  was  found  expedient  to  continue  this  policy. 
Recently,  however,  the  Treasury  Department  has  directed 
the  reserve  banks  to  hold  the  funds  of  the  goverrunent  on 
deposit. 

The  federal  reserve  banks  as  fiscal  agents  of  the  government 
handled  all  the  details  connected  with  the  sale,  allotment,  dis- 
tribution, and  redemption  of  Treasury  certificates  of  indebted- 
ness (through  which  the  Treasury  anticipated  the  proceeds  from 
the  sale  of  Liberty  bonds  and  Victory  notes)  among  member 
and  non-member  banks;  received  subscriptions  to  the  loans;  and 
collected  all  note  and  certificate  payments.  They  undertook 
the  various  exchanges  of  bonds  and  paid  coupons  of  war  securities 
as  they  fell  due.^  As  illustrating  this  fiscal  service,  it  may  be 
noted  that  in  19 19  nearly  ;^^  million  government  checks  amount- 
ing to  over  $14  billion  passed  through  the  federal  reserve  banks 
and  their  branches,  and  that  these  banks  paid  over  100  miUion 
Liberty  bond  and  Victory  note  coupons. 

References 

Agger,  E.  E.     Organized  Banking,     pp.  241-264. 

Conway,  T.,  and  Patterson,  E.  M.    The  Operation  of  the  New  Bank  Act. 

A  full  and  detailed  account  of  the  purposes  of  the  Federal  Reserve 
Act,  but  needs  to  be  supplemented. 
Dunbar,  C.  F.     Theory  and  History  of  Banking,     pp.  249-291. 
Fiske,  A.  K.     The  Modern  Bank.     pp.  25-38. 
Holdsworth,  J.  T.     Money  and  Banking. 

Contains  reprint  of  the  Federal  Reserve  Act  with  amendments 
to  April  13,  IQ20,  pp.  375-449;  453-510. 
Johnson,  J.  F.     Money  and  Currency,     pp.  374-379. 
Kemmerer,  E.  W.     The  A.  B.  C.  of  the  Federal  Reserve  System. 

A  concise  and  clear  explanation. 
Moulton,  H.  G.  Financial  Organization  of  Society,    pp.  574-618. 


*  Sixth  Annual  Report  of  the  Federal  Reserve  Board,  1919,  p.  25. 


332  BANKING  AND  CREDIT  [  XXIII 

Moulton,  H.  G.     Principles  of  IMoney  and  Banking.     Part  II. 

Presents  general  description  with  extracts  from  difTerent  writers, 
pp.  259-280. 
National  City  Bank  of  New  York.    National  Banking  under  the  Federal 
Reserve  System. 

Contains  Federal  Reserve  Act  and  explanatory  text  of  most  im- 
portant sections. 
Phillips,  C.  A.     Readings  in  Money  and  Banking. 

Extracts  from   writings   published   before   enactment  of  amend- 
ments of  1Q17,  pp.  723-706. 
Westerfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  II,  pp.  238- 

271; 285-295. 
Willis,  11.  P.     Federal  Reserve. 

A  detailed  study  of  the  several  functions  of  the  new  system  and  a 
digest  of  the  act  in  the  Appendix. 
and  Edwards,  G.  W.     Banking  and  Business,    pp.  414-439. 


CHAPTER   XXIV 

REDISCOUNTING  BY   FEDERAL   RESERVE   BANKS 

I.  Early  Development  of  the  Federal  Reserve  System. — The 

preceding  chapter  describes  the  principal  characteristics  of  the 
federal  reserve  system.  In  the  main  it  dealt  with  the  funda- 
mental provisions  of  the  law  rather  than  with  the  results  of  opera- 
tion. With  this  description  in  mind  these  provisions  may  be 
more  clearly  understood  by  a  brief  historical  rev-iew  of  the  changes 
resulting  from  the  new  banking  plan. 

The  development  of  the  federal  reserve  system  is  a  striking 
illustration  of  the  rapid  and  unexpected  changes  which  are  char- 
acteristic of  American  economic  life.  The  framing  and  passage 
of  the  act  was  attended  by  partizan  debate.  Many  national 
banks  which  were  compelled  to  become  members,  and  to  that 
extent  support  the  system,  did  so  without  enthusiasm  and 
assumed  an  attitude  of  toleration  rather  than  of  helpful  co- 
operation; state  banks  and  trust  companies  were  open  in  their 
opposition  and  endeavored  to  bring  the  new  system  into  disre- 
pute; and,  as  industry  was  stagnant  and  did  not  call  into  activity 
the  latent  force  of  the  system  which  would  reveal  its  possible 
useful  service,  even  the  business  community  was  not  attracted 
to  its  support.  Many,  indeed,  were  unacquainted  with  its  opera- 
tion, or  if  informed  they  were  indifferent  either  as  to  its  estab- 
lishment or  to  its  continuance. 

In  November,  1914,  when  the  federal  reserve  banks  began 
operations,  the  capital  of  the  combined  12  regional  banks 
amounted  to  $18  million — less  than  that  of  individual  banks  in 
New  York  City;  investments  in  bills  or  loans  were  less  than  $6 
million  and  the  note  circulation  was  only  a  paltry  million  dollars. 
These  banks  held  a  considerable  volume  of  gold  and,  by  virtue  of 

333 


334  BANKING  AND  CREDIT  [  XXIV 

the  provision  requiring  the  member  banks  to  keep  a  portion  of 
the  reserve  with  the  12  regional  banks,  they  carried  $227  milHon 
of  deposits.  These  transactions  made  Httle  impression  on  the 
financial  world. 

Although  the  industrial  life  of  the  nation  was  quickened  in 
the  following  year,  191 5,  particularly  in  the  expansion  of  the 
export  trade,  the  banking  situation  remained  substantially  the 
same.  The  reserve  banks  had  a  little  more  capital,  as  the  sub- 
scriptions of  the  member  banks  by  that  time  had  been  paid  in; 
they  increased  their  gold  holdings  ($297  million),  and  the  re- 
serve deposits  were  somewhat  larger.  But  the  rediscounting 
function,  whereby  the  reserve  banks  were  expected  to  take  an 
intimate  part  in  financing  business,  was  still  inactive.  Bills 
held,  or  loans,  amounted  to  only  $43  million,  and  the  larger  part 
of  these  were  purchased  in  the  open  market;  federal  reserve  note 
issues  increased  to  nearly  $200  milhon,  but  only  $17  milHon  of 
this  was  secured  by  commercial  paper.  The  remainder  was 
based  upon  the  deposit  of  gold. 

2.  Activity  of  Reserve  Board. — The  Federal  Reserve  Board, 
however,  was  not  idle  during  this  period.  Opportunity  was  given 
to  outline  a  policy,  to  frame  its  regulations,  and  to  prepare  the 
system  for  the  tasks  which  might  subsequently  be  imposed 
upon  it.  The  different  classes  of  commercial  paper  eligible  for 
discount  at  the  federal  reserve  banks  were  carefully  defined; 
attention  was  given  to  the  development  of  bankers'  acceptances, 
hitherto  Httle  used  in  American  credit  practice;  and  eft'orts  were 
made  to  simplify  the  arrangements  whereby  state  banks  could 
be  admitted  to  the  system.  This  work  of  preparation  was,  how- 
ever, largely  internal  and  did  not  in  any  material  degree  affect  the 
credit  machinery  of  the  banks  of  the  country.  It  was  fortunate, 
indeed,  that  business  conditions  were  "easy"  and  that  as  yet  no 
strain  was  placed  upon  the  banks,  for  it  was  possible  for  the  Federal 
Reserve  Board  to  carry  on  a  campaign  of  education,  cultivate 


XXIV  ]  REDISCOUNTING  BY  FEDERAL  RESERVE  BANKS        335 

"good  relations  with  member  banks,"  and  thus  unify  the  banking 
agencies  of  the  nation,  as  was  contemplated  in  the  original  act. 

3.  Complaints  against  System. — In  1916  industry  speeded 
up  still  more  rapidly.  Even  if  the  United  States  was  not  in  the 
war,  it  was  called  upon  to  provide  commodities  for  the  war. 
The  flow  of  gold  which  set  in  from  Europe  in  the  preceding  year 
continued,  and  the  larger  part  was  absorbed  by  the  federal  re- 
serve banks,  swelling  the  amount  to  nearly  $700  million.  Com- 
mercial bill  holdings,  or  loans,  increased  to  a  little  over  $100 
million  ($117  million);  and,  against  the  increase  of  gold  and 
commercial  paper,  federal  notes  advanced  to  $239  million. 

But  even  after  two  years  of  operation  the  federal  reserve 
system  attracted  little  attention;  the  money  market  was  still 
easy,  due  in  a  large  measure  to  the  importation  of  gold;  and  mem- 
ber banks  were  able  to  furnish  loans  to  their  customers  without 
seeking  rediscounts.  Many  bankers  still  chafed  over  the  new 
centralizing  regulations  which  restricted  individual  freedom  of 
action;  they  objected  to  placing  banking  under  the  surveillance 
of  a  new  "master  of  the  house " ;  and  they  protested  because  they 
were  deprived  of  certain  profits  which  they  had  formerly  enjoyed. 
More  specifically  they  complained  that  membership  was  com- 
pulsory; that  member  banks  were  obliged  to  deposit  a  part  of 
their  reserve  with  the  federal  reserve  banks  which  paid  no  in- 
terest, as  compared  with  the  former  system  whereby  they  earned 
interest  on  deposit  balances  in  reserve  city  banks;  that  checks 
must  be  collected  at  par,  thus  cutting  off  revenue  which  banks 
derived  in  transferring  funds  from  one  place  to  another ;  and  that 
the  federal  reserve  banks  were  engaged  in  competitive  profit- 
seeking,  as  in  the  purchase  of  bank  acceptances  to  the  detriment 
of  member  banks.  As  for  the  federal  reserve  notes  which  began 
to  filter  into  general  circulation,  they  were  regarded  as  curiosities 
and  another  illustration  of  the  variegated  currency  which  the 
United  States  traditionally  enjoyed.     And  to  the  initiated  these 


336  BANKING  AND  CREDIT  [  XXIV 

notes  were  regarded  simply  as  gold  certificates,  being  backed  up 
by  the  gold  which  the  federal  reserve  banks  had  received  from 
member  banks  in  the  transfer  of  reserves. 

4.  Expansion  Due  to  the  War,  1917. — Then  came  the  war 
in  April,  191 7.  Suddenly  the  situation  changed  and  the  busi- 
ness world  quickly  realized  that  it  had  a  friend  in  time  of  need. 
The  federal  reserve  banks  were  called  upon  to  render  a  service 
not  contemplated  in  the  act  authorizing  the  new  system.  The 
title  of  the  Federal  Reserve  Act  reads  as  follows:  "To  furnish 
an  elastic  currency,  to  afford  means  of  rediscounting  commercial 
paper,  to  establish  a  more  effective  supervision  of  banking  in  the 
United  States,  and  for  other  purposes."  In  view  of  the  duties 
imposed  upon  the  reserve  banks,  it  would  have  been  more  specific 
to  have  inserted  in  this  title  an  additional  phrase,  "and  to  enable 
the  government  to  borrow  money." 

Upon  declaration  of  war  the  productive  capacity  of  industry 
essential  to  the  prosecution  of  war  was  taxed  to  the  utmost. 
Plans  were  instantly  made  on  a  prodigious  scale.  Never  was  a 
greater  strain  so  quickly  made  upon  the  credit  facihties  of  banks. 
But  more  than  that,  the  government  was  in  immediate  need 
of  funds;  and,  whatever  the  system  of  taxation,  funds  could 
be  had  quickly  only  through  borrowing.  In  the  light  of 
subsequent  experience  the  demand  which  the  government  then 
made  seems  pitifully  small.  Banking  experts  estimated  that 
only  between  $500  million  and  $1,500  million  of  bonds  could  be 
sold,  but  notwithstanding  these  discouraging  estimates  the 
Treasury  asked  for  $2  billion.  To  the  astonishment  of  all,  in- 
cluding the  experts,  the  people  replied  by  offering  to  take  $3 
billion.  Even  before  the  proceeds  of  this  loan  could  be  made 
available,  it  was  necessary  for  the  government  to  have  funds  and 
this  was  provided  by  the  issue  of  Treasury  short-term  certifi- 
cates. In  the  sale  of  these  as  well  as  of  the  bonds,  the  govern- 
ment turned  to  the  federal  reserve  banks  to  act  as  its  agent,  and 


XXIV]  REDISCOUNTING  BY  FEDERAL  RESERVE  BANKS        337 

through  this  service  these  institutions  were  brought  into  new  and 
close  relationships  with  the  banking  world. 

But  more  than  this  was  done.  Regulations  were  adopted 
whereby  member  banks  could  rediscount  at  federal  reserve  banks 
notes  secured  by  the  new  government  war  obligations  as  collateral. 
And  to  make  the  loaning  of  money  to  the  government  by  the 
purchase  of  bonds  as  easy  a  sacrifice  as  possible,  it  was  further 
ordered  that  the  discount  rate,  charged  by  the  federal  reserve  banks 
to  the  member  banks  on  notes  secured  by  these  war  obligations, 
would  be  no  greater  than  the  interest  granted  on  these  securities. 
This  policy  finally  brought  the  federal  reserve  system  close  to  the 
interests  of  the  great  body  of  the  population.  From  this  time  on 
the  federal  reserve  system  became  a  recognized  public  institution. 

5.  Rediscounting  of  Paper  Secured  by  War  Obligations. — 

Under  the  original  National  Banking  Act,  no  national  bank 
could  borrow  money  in  excess  of  its  capital.  The  Federal  Re- 
serve Act  amended  this  by  excepting  liabiHties  incurred  through 
rediscounts  at  the  federal  reserve  bank. 

It  was  not  contemplated  by  the  Federal  Reserve  Board  that 
the  member  banks  would,  except  to  meet  seasonal  requirements 
or  emergencies,  avail  themselves  of  this  amendment  in  order  to 
extend  their  rediscount  lines  beyond  the  original  limitations.  It 
was  the  Board's  view  also  that  as  a  rule  the  discount  rates  of  the 
federal  reserve  banks  should  be  higher  than  current  market  rates, 
thus  offering  no  incentive  to  member  banks  to  rediscount  for  the 
sake  of  making  a  profit  in  the  transaction.  ^ 

Owing  to  the  "abnormal  ease  of  money"  in  191 5  and  191 6 
the  efficiency  of  this  discount  policy  was  not  tested.  Not  until 
191 7  did  rediscounts  on  commercial  paper  show  any  marked  in- 
crease. The  needs  of  the  Treasury,  however,  occasioned  by  the 
entrance  of  the  United  States  into  the  war,  diverted  the  federal 
reserve  system  from  its  original  purpose.     Federal  reserve  banks 


Sixth  Annual  Report  of  the  Federal  Reserve  Board,  I9i9,p.68. 


338 


BANKING  AND  CREDIT 


XXIV 


were  authorized  to  discount  for  member  banks  notes  running  up 
to  90  days,  which  were  secured  by  government  obhgations,  and  a 
preferential  rate  of  discount  was  established  on  these  notes,  not 
exceeding  the  rate  of  interest  on  the  government  securities.  It 
was,  therefore,  impossible  for  the  federal  reserve  banks  to  develop 
an  independent  discount  policy  whereby  loaning  rates  would  be 
adjusted  to  the  needs  of  business  and  exercise  a  control  over  the 
rates  of  member  banks.  The  banks  were  cautioned  against 
making  loans  for  purposes  unessential  to  the  war,  but  in  estab- 
lishing low  rates  to  aid  borrowers  in  the  purchase  of  government 
securities,  there  was  opportunity  for  others  to  secure  credit  for 
private  ends.  Reliance  was  placed  upon  good  faith  instead  of 
control  through  banking  discount  procedure.  In  1919  loans  on 
government  obligations  far  exceeded  discounts  on  commercial 
paper.  ' '  The  federal  reserve  banks  became  great  bond  distributing 
organizations  " ;  "  the  credit  facihties  of  the  federal  reserve  banks 
were  placed  at  the  disposal  of  member  and  non-member  banks  in 
order  that  they  might  lerxd  freely  on  bonds  for  which  the  subscribers 
were  unable  to  pay."^  The  following  table  shows  the  amounts  of 
the  two  classes  of  rediscounts  during  the  years  1918-1921: 


Federal  Reserve  Rediscounts,  1Q18-1921 
(In  millions) 


Date 

Discounts  on 
Commercial  Paper 

Discounts  on  U.  S. 
Government 
Obligations 

$315-1 
628.9 
243-6 
251-4 
716-5 
1,250.6 
1,048.8 
591-2 

$312.5 

Tiilv-        26    IQ18 

673.2 

1.357-6 

Tulv          2=i.  IQIQ 

1,616.2 

1.457-9 

Tiilv           •^O    IQ20 

1,241.0 

1,407.7 

Tlllv            '>7     IQ^I                   

1.059.3 

2  Si.xth  Annual  Report  of  the  Federal  Reserve  Board,  IQIP.  P-  68. 


XXIV]  REDISCOUNTING  BY  FEDERAL  RESERVE  BANKS        339 

It  was  expected  by  many  that  the  rediscounts  on  govern- 
mental obhgations  would  rapidly  disappear  from  the  balance 
sheets  of  reserve  banks  upon  the  return  to  peace.  The  Federal 
Reserve  Board  recognized  that  a  "restoration  of  normal  condi- 
tions must  be  brought  about  through  the  gradual  elimination  of 
war  paper  from  the  banks."-*  Liberty  bonds,  however,  were 
below  par;  if  not  available  for  rediscounts  a  very  considerable 
amount  would  be  thrown  upon  the  market  for  sale.  This  would 
depress  the  price  and  discourage  the  holders,  many  of  whom 
originally  invested  under  conditions  of  great  sacrifice,  and  who 
could  not  understand  why  they  should  be  called  upon  in  times  of 
peace  to  make  still  further  sacrifice. 

6.  Rediscount  Policy  at  Close  of  the  War. — There  was  hesi- 
tation in  advancing  the  discount  rates  of  the  federal  reserve 
banks  in  191 9.  Apart  from  the  necessities  occasioned  by  the 
financing  of  the  Treasury,  it  was  held  that  European  countries, 
as  well  as  the  United  States,  were  extremely  short  of  goods,  and 
that  consequently  the  use  of  credit  for  producing  goods  should 
not  be  unduly  curtailed.  At  the  same  time  it  was  recognized 
that  there  was  an  immoderate  use  of  credit  by  those  engaged  in 
speculation  in  securities,  land,  and  commodities,  which  led  to 
higher  prices,  increased  cost  of  living,  and  laid  the  foundations 
for  future  collapse  and  depression. 

The  difficulty  of  the  problem  was  commented  upon  by  the 
Federal  Reserve  Board  as  follows:'' 

The  extent  to  which  the  Federal  Reserve  Bank  rates  may 
normally  be  expected  to  be  "  effective,"  in  the  sense  in  which  that 
term  is  used  in  England  and  Continental  Europe,  still  remains  to 
be  determined.  ...  It  seems  doubtful  whether,  for  a  long 
time  to  come  and  taking  the  countrs  as  a  whole,  there  will  be  any 
such  close  connection  of  Federal  Reserve  Bank  rates  with  the 


3  Ibid.,  p.  2. 

4  Federal  Reserve  Bulletin,  October  1919.  p.  <jii. 


34<^>  BANKING  AND  CREDIT  [  XXIV 

volume  of  credit  in  use  as  was  to  be  noted,  for  example,  in  pre-war 
days  in  England,  the  home  of  central  banking. 

The  habitual  temper  of  the  American  business  community  is 
sanguine  and  American  business  is,  for  the  most  part,  done  on 
liberal  margins.  The  bulk  of  the  requirements  for  credit  facilities 
comes  from  industry  and  trade  mainly  domestic  in  its  origin  and 
character.  Such  a  condition  does  not  make  for  sensitiveness  to 
the  influence  of  changing  rates  such  as  was  the  case  in  England, 
where  such  business  is  done  on  a  narrow  margin  of  profit  and 
where  banking  resources  were  normally  employed  largely  in  the 
international  loan  market.    .    .    . 

The  problem  of  controlling  the  volume  and  uses  of  credit  in  a 
country  with  so  much  diversity  of  business  interests  and  business 
temper  as  the  United  States  is  far  from  simple  and  far  from  cer- 
tain of  solution.  Experience  alone  can  determine  whether  and  in 
what  manner  a  technique  of  control  through  rates  can  be  devel- 
oped which  will  secure  the  desired  results. 

Moreover,  the  Treasury  was  still  obliged  to  make  temporary 
borrowings  through  the  issue  of  short-term  certificates  of  in- 
debtedness. The  rates  of  interest  on  these  obligations  did  not 
attract  private  investors  and  the  banks  were  called  upon  to 
purchase  large  amounts.  This  they  would  not  do  unless  assured 
that  these  investments  would  be  carried  by  the  reserve  banks 
without  loss.  Consequently  the  Federal  Reserve  Board 
proceeded  cautiously. 

7.  Check  of  Credit  Expansion. — It  was  not  until  November, 
1919,  a  year  after  the  armistice,  that  the  reserve  banks  advanced 
rates.  For  many  months  the  rates  on  commercial  paper  had 
varied  from  4  to  5  1/2  per  cent  according  to  maturity;  they  were 
then  gradually  raised  to  6  per  cent  by  8  of  the  reserve  banks  and 
to  7  per  cent  by  4  of  the  banks.  While  this  advance  checked 
the  rate  of  credit  expansion,  it  did  not  cause  contraction. 
Credit  expansion  had  already  received  such  impetus  that  it  was 
difficult  to  bring  it  under  control.  A  new  device  was  therefore 
sought  by  an  amendment  to  the  Federal  Reserve  Act,  April  13, 


XXIV  I  REDISCOUNTING  BY  FEDERAL  RESERVE  BANKS        341 

1920;  by  this,  federal  reserve  banks  were  authorized  to  charge 
rates  "graduated  or  progressed  on  the  amount  of  the  advances 
or  discount  accommodations  extended  by  the  federal  reserve 
bank  to  the  borrowing  bank."  Four  reserve  banks  adopted  this 
method.  Loans  were  thus  distributed  more  evenly  to  the  mem- 
ber banks,  but  credit  expansion  as  a  whole  was  only  slightly 
affected  by  such  measures. 

During  1920  the  situation  slowly  improved.  Liberty  bonds 
were  being  slowly  absorbed  by  private  investors,  partly  due  to  a 
growing  appreciation  of  the  investment  merit  of  these  securities, 
and  partly  due  to  the  advancing  rates  of  interest  charged  by 
member  banks  in  response  to  the  higher  rediscount  rates  of  the 
federal  reserve  banks.  In  one  year,  between  November,  1919, 
and  November,  1920,  the  holdings  of  the  federal  reserve  banks 
of  bills  discounted  on  United  States  government  obligations  fell 
from  $1,701  million  to  $1,181  million.  In  1921  further  progress 
was  made  and  by  the  end  of  the  year  this  class  of  discounted  bills 
amounted  to  less  than  $500  million,  as  compared  with  approxi- 
m_ately  $700  million  of  rediscounts  on  commercial  paper. 

In  December,  1920,  the  Federal  Reserve  Board  did  away  with 
the  differential  rate  in  favor  of  paper  secured  by  war  obligations, 
excepting,  however,  the  Treasury  certificates  of  indebtedness. 
Not  until  the  middle  of  1920  did  rediscounts  on  commercial 
paper  equal  those  secured  by  war  obligations,  and  after  that  date 
they  were  in  excess.  It  is  impossible  as  yet  to  determine  in 
what  degree  commercial  rediscounts  are  functioning  in  response 
to  business  and  commercial  fluctuations,  as  was  anticipated  by 
the  founders  of  the  system.  The  reduction  of  discounts  of  paper 
secured  by  war  obligations  in  1920  was  more  than  offset  by  the 
discounts  on  "other"  commercial  paper.  Notwithstanding 
the  decline  in  business  in  the  latter  half  of  1920  and  the  decrease 
in  rediscounts  on  war  obligations,  the  total  volume  of  rediscounts 
was  greater  in  December  than  in  July.  The  question  therefore 
arises  as  to  whether  the  member  banks  were  not  borrowing  on 


342 


BANKING  AND  CREDIT 


[XXIV 


notes  representing  renewals  and  credits  which  were  not  easily 
liquidated. 


8.  Volume  of  Rediscounts. — The  balance-sheet  figures  of 
bills  discounted  do  not  adequately  indicate  the  service  which  the 
federal  reserve  banks  are  rendering  in  the  supply  of  credit  facili- 
ties. The  discounts  are  for  but  short  periods;  purchase  and 
liquidation  are  in  constant  operation.  For  example,  of  the 
$2,719  million  bills  held  December  30,  1920,  three-fifths  matured 
within  15  days  and  about  a  fourth  more  within  60  days.  To 
maintain  these  figures  it  is  therefore  necessary  for  the  reserve 
banks  to  discount  during  the  month  several  times  the  foregoing 
amounts.  This  is  seen  in  the  following  table  showing  the  total 
volume  of  discounts  by  years: 

Volume  of  Federal  Reserve  Discounts  by  Years 


Date 

Bills  Discounted  for 
Member  Banks 

Yearly  Increase  of 
Bills  Discounted 

1915 
1916 
1917 
1918 
1919 
1920 

$161,353,000 
207,870,000 

8,968,990,000 
39,752,934,000 
79.173.970.000 
85,320,874,000 

$46,518,000 

8,761,121,000 

30,783,943,000 

38,421,036,000 

6,146,904,000 

The  former  prejudice  against  seeking  rediscounts  has  prac- 
tically disappeared.  Not  all  member  banks,  however,  find  it 
necessary  to  seek  credit  from  the  reserve  system.  The  propor- 
tion of  banks  accommodated  is  somewhat  higher  in  the  South 
and  West  than  in  the  East,  and  this  is  what  might  be  expected  as 
there  is  less  accumulated  capital  in  those  sections.  In  1920 
about  one-half  the  member  banks  of  the  entire  system  sought 
accommodation  at  one  time.     In  October  the  highest  percentage 


XXIV  1  REDISCOUNTING  BY  FEDERAL  RESERVE  BANKS       343 

was  in  the  Atlanta  district,  72  per  cent;  and  the  lowest  in  the 
Cleveland  district,  28  per  cent. 

9.  Increase  in  Bankers*  Acceptances. — Credit  facilities  have 
been  extended  not  only  through  rediscounts  but  by  the  greater 
use  of  bankers'  acceptances.  This  development  is  shown  by  the 
following  figures  which  represent  the  total  volume  of  acceptances 
purchased  annually  in  the  open  market  by  federal  reserve  banks: 

191 5 $5,000,000 

1916 386,000,000 

191 7 909,000,000 

1918 1,810,000,000 

1919 2,825,000,000 

1920 3,218,000,000 

It  is  estimated  that  at  the  close  of  1920  the  maximum  ac- 
ceptance power  of  the  members  of  the  federal  reserve  system 
was  over  $3  billion,  and  that  other  banks  had  an  acceptance 
power  of  more  than  half  a  billion.  At  the  same  time  there  were 
outstanding  a  little  over  a  billion  dollars  of  acceptances,  showdng 
that  this  new  credit  facility  was  being  rapidly  extended.  These 
acceptances  are  growing  in  favor  not  only  with  commercial 
banks,  which  seek  liquid  investments,  but  also  with  savings  banks, 
which  can  thus  temporarily  employ  their  funds  while  seeking 
for  advantageous  long-term  commitments. 

References 

Westerfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  II,  pp.3 74- 

386. 
Willis,  H.  P.,  and  Edwards,  G.  W.     Banking  and  Business,     pp.  450-453. 


CHAPTER  XXV 

OTHER  OPERATIONS  OF  FEDERAL  RESERVE  BANKS 

I.  Note  Issues  under  the  Original  Act. — Federal  reserve 
notes  are  issued  to  a  reserve  bank  by  the  federal  reserve  agent 
acting  as  the  representative  of  the  Federal  Reserve  Board. 
Promptness  of  action  and  continuity  of  policy  is  secured  by  mak- 
ing the  agent  one  of  the  members  of  the  directorate  of  the  bank. 
Under  the  original  act  the  bank  pledged  commercial  paper  with 
the  federal  reserve  agent,  and  received  in  return  federal  reserve 
notes,  in  equal  amounts.  Subsequent  regulations,  however, 
permitted  the  bank  to  substitute  gold  in  place  of  the  commercial 
paper  pledged  as  collateral.  Since  the  banks  held  an  increasing 
amount  of  gold  due  to  deposits  made  by  member  banks  and  it 
was  their  policy  to  centralize  the  gold  fund  of  the  country  as 
largely  as  possible  under  their  own  control,  they  soon  adopted 
the  practice  of  withdrawing  the  commercial  paper  from  the  pos- 
session of  the  reserve  agent  and  substituting  gold.  The  gold 
thus  surrendered  no  longer  was  counted  as  part  of  the  general 
gold  reserve  of  the  bank.  Under  this  procedure  a  large  part  of 
the  reserve  notes  became  practically  gold  certificates  and  did  not 
increase  the  total  volume  of  currency.  Gold  was  simply  con- 
verted into  reserve  notes.  For  example,  on  January  28,  1916, 
there  were  $179,000,000  notes  outstanding;  although  originally 
called  into  existence  by  the  pledge  of  commercial  paper,  on  the 
date  named,  they  were  secured  by  only  $15,000,000  commercial 
paper  and  by  $205,000,000  gold.  Again,  at  the  close  of  the  year 
(December  30)  there  were  $300,110,000  of  reserve  notes,  but 
only  $17,588,000  were  secured  on  that  date  by  eligible  paper 
pledged  with  the  agents,  the  banks'  liabiHty  on  the  remainder 
having  been  reduced  by  the  deposit  of  gold. 

344 


XXV^]  OTHER  FEDERAL  RESERVE  BANK  OPERATIONS    345 

2.  Later  Provisions  for  Note  Issue. — This  relationship  of  a 
surplus  gold  collateral  continued  until  the  act  was  amended 
June  21,  191 7;  the  banks  were  then  permitted  to  deposit  gold 
directly  for  the  issue  of  notes,  and,  what  was  more  important, 
permission  was  given  the  banks  to  count  the  gold  deposited  with 
agents  as  part  of  the  gold  reserve.  Notes  could  be  issued  both 
against  gold  alone  and  against  gold  and  eligible  paper  as  security, 
the  gold  thus  acquired  serving  as  part  of  the  required  reserve  of 
40  per  cent  against  notes  and  of  35  per  cent  against  deposits. 
This  amendment  gave  new  impetus  to  the  issue  of  federal  re- 
serve notes.  Notes  could  now  be  issued  against  collateral  of 
60  per  cent  commercial  paper  and  40  per  cent  gold,  instead  of  100 
per  cent  commercial  paper  and  40  per  cent  gold. 

3.  Note  Issue  Increase. — The  following  table  shows  the 
growth  of  note  issues: 

Thousands  Thousands 

January  29,  191 5 $14,500  July         26,1918 $1,870,835 

July         30,1915 85,127  January  31,  1919 2,450,729 

January  28,  1916 179,224  July         25,1919 2,504,497 

July         28,1916 152,590  January  30,  1920 2,850,944 

January  26,  191 7 259,768  July         30,1920 3,120,138 

July         27,1917 534,015  January  28,  192 1 3,090,748 

January  25,  1918 1,234,934  July         27,1921 2,537,617 

It  will  be  observed  that  a  marked  increase  took  place  in  the 
latter  half  of  191 7.  The  significance  of  this,  made  possible  by 
the  amendment  Hberating  gold,  may  be  seen  still  more  clearly 
in  the  table  on  page  346. 

Between  June  and  November  in  191 7,  notes  resting  upon 
a  credit  basis  were  put  into  circulation  to  the  extent  of 
$342,679,000,  of  which  nearly  $200,000,000  were  issued  in  the 
seven  weeks  ending  November  16.  The  increase  in  notes  during 
19 1 7  and  19 18  was  largely  due  to  the  discount  by  reserve  banks 


346 


BANKING  AND  CREDIT 


[XXV 


on  paper  secured  by  war  obligations  of  the  government.  In 
April,  19 1 7,  when  the  United  States  entered  the  war,  the  volume 
of  notes  issued  was  $400  million ;  at  the  time  of  the  Armistice,  it 
was  approximately  $25  million. 

Federal  Reserve  Note  Circulation  and  Gold  Reserve 

(Amounts  in  thousands) 


I9I7 

Total    Circulation 
of  Notes 

Gold  Reserve 

Percentage  of  Gold 

Reserve  to  Total 

Circulation 

Credit  Basis 
of  Notes 

May              25 

SJ54.402 

$456,611 

IOCS 

June              29 

508, 8C7 

402,693 

81.0 

$106,114 

July               27 

534.015 

434,193 

83.0 

99,823 

August         31 

587.91S 

493.185 

85. 1 

94.730 

September  28 

699.343 

555,239 

80.8 

144.104 

October       26 

847,506 

614,692 

73.8 

232,814 

November  16 

972,585 

629,906 

65.9 

342,679 

Under  the  amendment  of  191 7  a  federal  reserve  bank  may 
deposit  $1,000,000  of  gold  and  receive  an  equal  amount  of  notes; 
the  $1,000,000  of  gold  may  then  be  used  as  the  40  per  cent  re- 
serve needed  to  obtain  $2,500,000  additional  notes  through  the 
pledge  of  commercial  paper.  Truly,  "  the  capacity  of  the  system 
to  adapt  its  operations  more  closely  to  the  changing  requirements 
of  the  public"  was  ''greatly  enlarged."^  By  these  changes, 
according  to  the  Federal  Reserve  Board,  the  federal  reserve  note, 
instead  of  being  "an  occasional  emergency  currency  used  to 
supplement  deficiencies  in  the  supply  of  other  existing  forms  of 
currency,  is  becoming  the  most  important  constitutent  of  our 
circulating  medium,  responding  promptly  and  naturally  to  cur- 
rency requirements  from  whatever  source  proceeding,  thus  prom- 
ising to  give  to  our  whole  currency  a  kind  and  degree  of 
elasticity  it  has  never  before  possessed." 


'  Fourth  Annual  Report  of  the  Federal  Reserve  Board,  1917,  p.  11. 


XXV  ]      OTHER  FEDERAL  RESERVE  BANK  OPERATIONS         347 

4.  Expansion  Due  to  War  Financing. — This  anticipation 
might  possibly  have  been  fulhlled  if  it  had  not  been  for  the  redis- 
counting  of  bills  based  on  war  obligations  already  described.  A 
very  considerable  part  of  the  note  issues  since  191 7  has  been 
created  by  the  pledge  of  government  securities.  To  that  ex- 
tent the  issue  is  another  example  of  bond-secured  currency, 
similar  in  principle,  though  created  by  different  machinery,  to 
that  of  the  national  banking  system.  Instead  of  a  national  bank 
buying  bonds,  to  be  pledged  with  the  Treasurer  of  the  United 
States,  on  which  national  bank  notes  are  issued,  the  member 
bank  appHed  to  the  federal  reserve  bank  for  a  loan  giving  as 
collateral  government  war  obligations  which  it  owned,  or  a 
customer's  note  secured  by  similar  obligations.  The  federal  re- 
serve bank  deposited  this  collateral  mth  the  federal  reserve  agent 
and  received  in  return  federal  reserve  notes  which  were  paid  to 
the  borrowing  bank. 

Elasticity  of  currency  implies  contraction  as  well  as  expan- 
sion. Because  of  the  heavy  responsibility  which  was  placed 
upon  the  federal  reserve  system  in  aiding  the  government  to 
finance  its  loans,  expansion  was  the  rule.  The  higher  level  of 
prices  also  tended  to  create  a  greater  volume  of  currency.  In 
only  one  month  in  1918  was  there  a  decrease  in  federal  re- 
serve notes;  and  in  1919,  two  months.  If  shorter  periods,  or 
weeks,  be  analyzed,  examination  shows  5  separate  weeks  of  con- 
traction in  1918  and  17  in  1919.  The  17  decreases  in  1919 
totaled  $374  million,  but  the  net  gain  was  $544  million.  Analysis 
also  shows  that  there  was  an  acceleration  in  the  rate  of  expansion 
beginning  with  September,  and  a  recession  in  the  early  weeks  of 
each  year,  corresponding  with  a  lessened  demand  for  currency 
for  crop-moving  and  Christmas  trade. ^ 

5.  Maintenance  of  the  Reserve. — The  rapid  increase  in  the 
deposits  of  member  banks  and  the  expansion  of  notes,  each  of 

^  Federal  Reserve  Bulletin,  November  1919,  P-  1043. 


348  BANKING  AND  CREDIT  I XXV 

which  must  be  protected  by  a  reserve,  is  reflected  in  the  large 
additions  of  gold  holdings.  At  times,  however,  the  maintenance 
of  the  reserve  required  by  law  has  been  a  serious  task.  The 
relationship  between  deposits,  notes,  and  reserve  for  the  whole 
system  is  seen  in  the  table  on  page  349  which  gives  figures  for  two 
dates  in  each  year:  (i)  date  of  maximum  reserve  ratio  within  the 
year,  (2)  date  of  minimum  reserve. 

6.  Protection  of  Reserve  by  Interbank  Rediscount. — It  will 
be  noted  that  the  reserve  needed  for  notes  since  the  middle  of 
1918  is  much  greater  than  the  reserve  for  deposits,  due  to  the  in- 
crease of  discounts  or  loans  to  member  banks  which  are  made 
possible  by  the  issue  of  notes.  The  deposits  do  not  fluctuate 
greatly,  but  the  demand  of  member  banks  for  rediscounts  from 
their  respective  regional  institutions  varies  over  a  wide  range  at 
different  periods  of  the  year.  An  equilibrium  has  been  main- 
tained by  interbank  accommodations,  or  rediscounts  between 
federal  reserve  banks.  If  it  had  not  been  for  such  accommoda- 
tions, all  the  federal  reserve  banks,  except  Cleveland  and  San 
Francisco,  would  at  times  have  shown  ratios  far  below  the  legal 
requirements.  The  series  of  charts  in  Form  18  shows  the  reserve 
percentages  of  federal  reserve  banks  each  week  in  1920,  as  they 
would  have  appeared  if  no  borrowing  had  taken  place  between 
federal  reserve  banks.  ^ 

Reserves  in  individual  banks  would  have  fallen  as  low  as  9 
per  cent  and  risen  as  high  as  81  per  cent.  By  transferring  the 
reserves  from  banks  which  had  ample  surplus  to  those  in  need  of 
credit  the  temporary  strain  was  lightened. 

The  reserves  of  the  system  as  a  whole  fluctuated  between  the 
narrow  limits  of  45.8  per  cent  and  41.4  per  cent.  .  .  .  These 
operations  were  effected  instantly  over  private  telegraph  lines 
and  settled  for  daily  by  the  gold  settlement  fund.  Thereby, 
the  twelve  reserve  banks,  for  all  purposes  requiring  the  extension 


^  Sixth  Annual  Report  of  Federal  Reserve  Bank  of  New  York,  1920,  p.  12. 


XXV  J     OTHER  FEDERAL  RESERVE  BANK  OPERATIONS 


349 


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350  BANKING  AND  CREDIT  [  XXV 

or  transfer  of  credit  between  various  sections  of  the  country 
became  in  effect  a  single  reservoir  of  credit.  "• 

7.  "  Free  Gold." — In  the  table  showing  the  reserves  of  the 
federal  reserve  banks  the  term  "free  gold"  is  used.  This  is  the 
gold  held  in  excess  of  what  is  required  as  reserves  against  net 
deposit  and  note  liabilities.  This  excess  of  free  gold  can  be  used 
as  the  basis  of  further  reserve  deposit  credit  or  additional  note 
circulation.  During  the  first  year  of  the  federal  reserve  system 
the  amount  of  free  gold  was  very  large  as  note  circulation  was 
small.  With  the  increase  in  deposits  and  notes,  more  and  more 
gold  was  needed  for  the  reserves.  At  the  beginning  of  1919,  the 
free  gold  of  the  12  banks  amounted  to  $550,000,000.  At  the 
close  of  the  year  it  declined  to  $316,000,000.  If  it  be  assumed 
that  for  every  $2  of  increase  in  net  deposits  there  is  an  increase 
of  $3  in  federal  reserve  notes,  the  last  amount  of  free  gold  might 
have  been  converted  into  reserve  gold  to  protect  $332,540,000  of 
net  deposits  and  $498,810,000  of  reserve  note  circulation.^  This 
represented  the  potential  expansion  at  the  close  of  1919.  If 
the  district  banks  are  able  to  accumulate  a  still  larger  part  of  the 
gold  stock,  a  still  further  extension  of  note  issues  is  possible 
without  going  below  the  normal  reserve  limits  fixed  by  law. 

8.  Earnings  and  Dividends  of  Federal  Reserve  Banks. — The 

federal  reserve  banks  are  permitted  to  accumulate  from  their 
earnings  a  surplus  equivalent  to  100  per  cent  of  the  subscribed 
capital.  After  this  surplus  is  accumulated  and  6  per  cent  divi- 
dends paid  on  the  stock,  90  per  cent  of  the  net  profits  must  be 
paid  to  the  government  as  a  franchise  tax,  the  remaining  10 
per  cent  being  added  to  the  surplus. 

The  earnings  of  the  federal  reserve  banks  are  large.  In  1919 
the  net  earnings  were  $82,000,000,  or  98  per  cent  on  the  paid-in 


''  Sixth  Annual  Report  of  Federal  Reserve  Bank  of  New  York,  1920,  p.  13. 
5  Federal  Reserve  Bulletin,  February  1920,  pp.  145-146. 


XXV]     OTHER  FEDERAL  RESERVE  BANK  OPERATIONS         35 1 


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Form  1 8.     Charts  of  Reserve  Percentages  of  Federal  Reserve  Banks 
(see  page  348) 


352  BANKING  AND  CREDIT  [  XXV 

capital;  and  in  1920,  $151,000,000,  or  nearly  161  per  cent  on  the 
capital.  In  the  latter  year,  9  of  the  1 2  district  banks  had  reached 
a  surplus  of  more  than  100  per  cent,  thus  establishing  super- 
surplus  accounts.  These  large  earnings  have  aroused  criticism 
from  those  who  believe  that  the  reserve  banks,  like  public  utili- 
ties, should  be  restricted  to  moderate  profits.  As  the  earnings 
are  derived  from  the  rediscounts  made  to  member  banks,  these 
critics  argue  that  the  reserve  banks  should  lower  their  discount 
rates  and  thus  make  it  possible  for  borrowers  of  member  banks 
to  obtain  loans  at  reduced  rates.  To  do  this,  however,  would 
run  counter  to  the  principles  of  sound  centralized  banking  and 
result  in  inflation. 

The  larger  earnings  of  the  reserve  banks  are  due,  not  to  ex- 
cessive rates  of  rediscount  but  to  the  large  volume  of  busi- 
ness, calling  for  rediscounts,  which  the  member  banks  transact. 
If  the  reserve  banks  discounted  at  more  favorable  rates,  the 
member  banks  would  be  tempted  to  extend  their  loans  and  the 
volume  of  business  would  be  still  larger.  Moreover,  the  reserve 
banks  are  able  to  make  the  large  volume  of  rediscounts  only 
through  the  issue  of  federal  reserve  notes.  If  rediscounts  were 
increased,  more  notes  would  be  issued,  the  currency  would  be 
increased,  and  the  reserve  banks  would  become  involved  in  a 
continuous  policy  of  inflation.  The  reserve  banks  retain  only 
a  small  part  of  the  earnings  after  the  surplus  is  once  established. 
Ninety  per  cent  goes  back  to  the  federal  Treasury,  and  the 
government  is  pledged  to  use  this  either  for  strengthening  the 
gold  reserve  to  protect  the  legal  tender  issues,  or  to  purchase 
outstanding  bonds.  Thus  the  public  gets  back  the  profits  which 
were  created  by  borrowers. 

9.  The  Balance  Sheet  of  a  Federal  Reserve  Bank. — The 

operations  of  a  federal  reserve  bank  may  be  more  clearly  under- 
stood by  a  consideration  of  a  balance  sheet.  For  this  purpose 
that  of  the  New  York  Federal  Reserve  Bank  on  December  30, 


XXV]     OTHER  FEDERAL  RESERVE  BANK  OPERATIONS         353 

1920,  is  given.  (Numbers  are  prefixed  to  the  items  for  purpose  of 
subsequent  reference.) 

Balance  Sheet  of  Federal  Reserve  Bank  of  New  York, 
December  30,  1920 

Resources 

Thousands 

1  Gold  and  gold  certificates $135,046 

2  Gold  settlement  fund,  Federal  Reserve  Board 36,435 

3  Gold  with  foreign  agencies 1,211 

4  Gold  with  federal  reserve  agents 254,575 

5  Gold  redemption  fund 39>ooo 

Total  gold  reserves $466,267 

6  Legal  tender  notes,  silver,  etc 143.975 

Total  reserves.  . $610,242 

Bills  discounted : 

7  Secured  by  government  war  obligations 445,926 

8  All  other 458,313 

9  Bills  bought  in  open  market 109,902 

10  United  States  government  bonds 1,468 

1 1  United  States  Victory  notes 50 

12  United  States  certificates  of  indebtedness 59.692 

Total  earning  assets $1,075,351 

13  Bank  premises 4.377 

14  Uncollected  items  and  other  deductions  from  gross  deposits  139,020 

1 5  Five  per  cent  redemption  fund  against  federal  reserve  bank 

notes 2,766 

16  All  other  resources 1.584 

Total  resources $1 ,833,340 

Liabilities 

17  Capital  paid  in $26,376 

18  Surplus  fund 51.308 

ig        Government  deposits 2,260 

20  Due  to  members — reserve  account 693,474 

21  Deferred  availability  items 94.273 

22  Other  deposits,  including  foreign  government  credits 11 ,284 

Total  gross  deposits $801,291 

23  Federal  reserve  notes  in  circulation 864,516 

24  Federal  reserve  bank  notes  in  circulation — net  liability . .  .  38,741 

25  All  other  liabilities 51.108 

Total  liabilities. $1,833,340 


354  BANKING  AND  CREDIT  [  XXV 

10.  Explanation  of  Items — Assets. — Gold  is  listed  under 
several  headings  according  to  the  special  service  it  performs: 

1.  Gold  and  gold  certificates.  This  is  the  gold  set  aside  as  a  reserve 
against  the  deposits  of  member  banks  and  federal  reserve  notes  which  have 
been  issued  to  the  bank. 

2.  Gold  settlement  fund,  Federal  Reserve  Board.  Instead  of  keeping 
all  its  gold  in  its  vault,  a  part  is  kept  by  the  Federal  Reserve  Board  (de- 
posited, however,  in  the  United  States  Treasury)  in  trust  for  the  district 
bank  to  be  used  in  making  transfers  to  other  federal  reserve  banks  or  to 
the  United  States  Treasury.  Such  transfers  may  be  large  owing  to  the 
clearing  house  operations  of  the  bank  and  its  fiscal  relationship  to  the 
government.  This  gold  may  be  included  in  the  reserve  against  deposits 
and  federal  reserve  notes. 

3.  Gold  with  foreign  agencies.  Gold  is  also  kept  with  agencies  which 
have  been  established  in  foreign  countries.  By  this  means  it  is  not  neces- 
sary to  make  so  frequent  shipments  in  the  settlement  of  foreign  transac- 
tions.   This  also  may  be  considered  as  part  of  the  reserve. 

4.  Gold  with  federal  reserve  agents.  This  is  the  gold  which  has  been 
deposited  with  federal  reserve  agents  as  collateral  for  federal  reserve  notes 
taken  out.  It  will  be  noted  that  this  is  more  than  one-half  of  the  total 
gold  held,  and,  as  already  pointed  out,  indicates  that  a  very  considerable 
amount  of  the  federal  reserve  notes  has  been  issued  in  exchange  for  gold. 
This  gold  may  also  be  considered  as  part  of  the  reserve  against  notes. 

5.  Gold  redemption  fund.  Each  federal  reserve  bank  must  keep  with 
the  Treasurer  of  the  United  States  a  small  amount  of  gold  for  the  redemp- 
tion of  its  notes  (Section  16,  paragraph  4).  This  is  included  in  the  reserve 
against  notes. 

The  foregoing  five  items  added  together  constitute  the  total  gold  re- 
serves to  protect  deposits  of  member  banks  and  note  liability. 

6.  Legal  tender  notes,  silver,  etc.  In  addition  to  gold  the  bank  holds 
other  forms  of  legal  tender  money.  This  may  be  counted  as  part  of  the 
reserve  against  deposits,  but  not  against  note  issues. 

Item  6  added  to  the  previous  gold  reserves  makes  the  total  reserves  on 
hand. 

7.  Bills  discounted,  secured  by  government  war  obligations.  These 
represent  loans  made  to  co-member  banks.  The  item  is  a  large  amount 
due  to  the  government's  extensive  financing.  The  Federal  Reserve  Act 
specifically  authorizes  a  federal  reserve  bank  to  discount  bills  secured  by  col- 
lateral in  the  form  of  government  securities  as  well  as  on  commercial  paper. 


XXV]  OTHER  FEDERAL  RESERVE  BANK  OPERATIONS    355 

8.  All  other  bills  discounted.  This  item  refers  to  commercial  paper  of 
the  classes  admissible  under  the  act,  which  the  bank  has  discounted  for 
member  banks,  and  also  includes  bills  discounted  for  other  federal  reserve 
banks,  and  bankers'  acceptances  bought  from  other  federal  reserve  banks 
with  or  without  their  indorsement.  This  item,  together  with  No.  g  follow- 
ing, measures  the  extent  to  which  the  district  banks  are  providing  credit 
based  on  the  ordinary  transactions  of  business. 

9.  Bills  bought  in  the  open  market.  Bankers' acceptances  are  included 
in  this  item. 

10.  II,  12.  United  States  government  bonds.  Victory  notes,  and  certi- 
ficates of  indebtedness.  These  represent  the  investment  of  the  bank's 
funds  in  government  securities,  and,  Hke  No.  7,  show  the  extent  to  which 
the  bank  is  involved  in  government  financing.  The  sum  of  the  bills  dis- 
counted, bills  bought,  and  government  securities,  makes  up  the  earning 
assets  of  the  bank  from  which  it  derives  its  profit. 

13.  Bank  premises.  This  is  self-explanatory,  representing  the  value 
at  which  the  office  and  its  equipment  is  carried  upon  the  books  of  the  bank. 

14.  Uncollected  items  and  other  deductions  from  gross  deposits. 
This  item  refers  to  credits  which  arc  in  process  of  collection,  particularly 
through  the  clearing  house  operations  of  the  bank. 

15.  Five  per  cent  redemption  fund  against  federal  reserve  bank  notes. 
Just  as  national  banks  are  required  to  keep  with  the  Treasurer  of  the 
United  States  a  fund  of  5  per  cent  of  the  bond  secured  currency,  so  a  fed- 
eral reserve  bank  which  is  taking  out  this  form  of  currency,  must  maintain 
a  redemption  fund. 

16.  All  other  resources  including  miscellaneous,  suspense,  and  adjust- 
ment accounts. 

II.  Liabilities. — On  the  liabilities  side  of  the  balance  sheet 
the  following  items  appear: 

17.  Capital  paid  in.  This  is  the  capital  stock  subscribed  by  the  mem- 
ber banks  of  the  district. 

18.  Surplus  fund.  Each  federal  reserve  bank  accumulates  a  surplus 
out  of  its  earnings. 

19.  Government  deposits.  Thishasalready  been  explained  on  page  330. 

20.  Due  to  members — reserve  account.  This  item  refers  to  the  de- 
posits which  the  member  banks  have  made  in  accordance  with  the  pro- 
vision that  these  institutions  must  keep  their  reserve  against  deposits 
with  the  federal  reserve  bank  of  their  district. 


356  BANKING  AND  CREDIT  |  XXV 

21.  Deferred  availability  items.  Each  member  bank  must  keep  on 
deposit  with  its  federal  reserve  bank  a  certain  sum  to  provide  for  the 
settlement  of  adverse  balances  arising  in  clearing-house  operations.  It 
also  includes  favorable  balances  which  member  banks  are  credited  with 
and  which  have  not  yet  been  withdrawn  or  transferred  to  the  deposit 
reserve  account.     (No.  20.) 

22.  Other  deposits,  including  foreign  governments  credits.  Banks 
which  are  not  member  banks,  as  well  as  foreign  governments  and  banks, 
may  have  deposits  in  the  federal  reserve  bank. 

23.  Federal  reserve  notes  in  actual  circulation.  This  represents  the 
total  amount  of  outstanding  notes  which  has  been  issued  by  the  Federal 
Reserve  Board  through  the  reserve  agent  to  this  particular  bank.  Any 
notes  which  the  bank  itself  may  hold  not  yet  paid  out  are  not  included. 

24.  Federal  reserve  bank  notes.  These  notes  are  explained  on  page 
326.  The  sum  given  in  the  balance  sheet  is  the  amount  which  the  New 
York  bank  has  taken  out  less  the  cash  which  has  been  deposited  with  the 
Treasurer  of  the  United  States  for  their  retirement. 

25.  All  other  liabilities. 

References 

Agger,  E.  E.    Organized  Banking,    pp.  265-307. 
Federal  Reserve  Board.    Annual  Report. 

Contains  not  only  reports  of  the  board,  but  also  the  annual  reports 
of  the  federal  reserve  agents  of  the  twelve  banks.     The  Seventh 
Annual  Report  covers  operations  for  1920. 
Federal  Reserve  Bulletin. 

Of  first  importance,  issued  monthly  by  the  Federal  Reserve  Board. 
This  appears  in  two  editions;  the  first  contains  announcements,  a 
review  of  business  conditions  and  other  general  matter  (price  $1.50). 
The  Final  Edition  includes  detailed  analyses,  special  articles,  review 
of  foreign  banking  and  current  statistics  showing  condition  of  federal 
reserve  banks  (price  $4.00). 
Moulton,  H.  G.     Financial  Organization  of  Society. 

The  war  and  the  federal  reserve  system,  pp.  624-646. 

Principles  of  Money  and  Banking.    Part  II. 

The  practical  workings  of  the  system,  pp.  282-287. 
Westerfield,  R.  B.     Banking  Principles  and  Practice. 

Note  issues.  Vol.  Ill,  pp.  350-373;  earnings,  pp.  260-262. 


CHAPTER  XXVI 

ACCEPTANCES 

I.  The  Use  of  Bankers'  Acceptances  Illustrated. — A  bankers' 
acceptance,  within  the  meaning  of  the  federal  reserve  regula- 
tions, is  defined  as  a  draft  or  bill  of  exchange  of  which  the  acceptor 
is  a  bank  or  trust  company,  or  a  firm,  person,  company,  or  cor- 
poration engaged  in  the  business  of  granting  bankers'  acceptance 
credits.  In  order  to  illustrate  the  operation  of  bankers'  ac- 
ceptances in  domestic  transactions,  let  us  suppose  that  Buyer 
and  Company  of  New  York  have  purchased  some  goods  from 
Seller  and  Company  of  St.  Louis.  Seller  and  Company  demand 
immediate  cash  payment,  but  Buyer  and  Company,  not  having 
sufficient  funds  at  their  immediate  disposal,  apply  to  their  bank 
in  New  York  for  assistance.  Instead  of  following  the  old  prac- 
tice of  borrowing  funds  on  a  note,  they  arrange  with  their  bank 
to  authorize  Seller  and  Company  to  draw  a  draft  on  the  bank  at, 
say,  60  days'  sight.  Having  shipped  the  merchandise.  Seller  and 
Company  proceed  to  draw  the  draft  and  then  take  it  together 
with  the  shipping  document  to  their  bank  in  St.  Louis,  which 
receives  the  item  for  collection,  and  sends  it  to  a  New  York  cor- 
respondent, which  in  turn  presents  it  to  the  drawee  (Buyer  and 
Company's  bank)  for  acceptance.  Whether  or  not  the  firm  in 
New  York  is  known  by  the  firm  in  St.  Louis  makes  very  little  dif- 
ference to  the  latter  if  it  can  produce  a  letter  stating  that  the  New 
York  bank  will  accept  its  draft.  This  bank  will  accept  the  bill 
provided  all  necessary  shipping  documents  conveying  and  secur- 
ing title  of  the  merchandise  to  itself  are  attached.  Upon  ac- 
ceptance the  bill  becomes  practically  the  same  as  a  promissory 
note  of  the  drawee  and  is  given  wide  negotiability. 

The  disposition  of  the  draft  will  now  depend  upon  instruc- 

357 


358  BANKING  AND  CREDIT  [  XXVI 

tions  from  the  St.  Louis  bank.  The  latter  will  probably  stipu- 
late either  that  the  draft  be  held  until  maturity  for  payment  or 
that  it  be  sold  in  the  New  York  market,  the  proceeds  being  placed 
to  the  credit  of  the  St.  Louis  bank;  or  it  may  require  that  the 
acceptance  be  returned  to  St.  Louis.  At  the  time  of  acceptance 
the  drawee  bank  detaches  and  retains  the  shipping  documents, 
the  final  disposition  of  which  will  depend  upon  the  agreement 
between  the  bank  and  its  customer. 

2.  No  Cash  Advanced  by  Accepting  Bank. — It  will  be  noticed 
that  in  the  illustration  the  accepting  bank  did  not  advance  any 
cash  but  simply  loaned  its  credit.  Of  course,  it  will  expect  its 
client  to  provide  the  necessary  funds  before  the  expiration  of  60 
days  to  meet  the  draft  at  maturity.  The  turnover  of  the  mer- 
chandise purchased  by  Buyer  and  Company  will  probably 
have  supplied  these  funds  and  will  have  thus  made  the  transac- 
tion self-liquidating. 

Although  the  accepting  bank  did  not  advance  any  cash,  its 
credit  risk  was  precisely  as  great  as  if  a  money  loan  based  on  the 
same  collateral  had  been  made  to  Buyer  and  Company.  The 
bank  became  legally  bound  to  pay  the  draft  at  maturity  even  if 
Buyer  and  Company  did  not  provide  the  necessary  funds  before 
the  expiration  of  60  days.  Whatever  loss  resulted  from  the 
default,  if  the  collateral  (shipping  documents)  had  been  sur- 
rendered or  did  not  realize  sufficient  proceeds  to  cover  the  ac- 
ceptances, would  be  borne  by  the  accepting  bank.  The  bank  will, 
of  course,  charge  a  commission  for  its  risk  and  service.  Although 
the  rates  for  acceptance  commissions  vary,  depending  upon  the 
time  as  well  as  the  risk  involved,  the  customary  charges  range 
from  1/4  to  3/8  per  cent  for  every  90  days  or  from  i  to  i  1/2  per 
cent  per  annum. 

3.  Shipping  Documents. — Let  us  now  return  for  a  moment  to 
the  matter  of  the  shipping  documents  retained  by  the  drawee 


XXVI  ]  ACCEPTANCES  359 

bank  at  the  time  of  the  acceptance  of  the  draft.  Buyer  and 
Company  will  wish  to  obtain  these  documents  for  the  purpose  of 
getting  the  merchandise  from  the  railroad  company,  which  will 
demand  the  bill  of  lading  before  surrendering  the  shipment.  In 
order  to  provide  the  greatest  practicable  security  the  most  de- 
sirable thing  for  the  bank  to  do  would  be  to  require  its  customer 
to  store  the  goods  in  a  public  warehouse  to  be  held  there  under 
the  bank's  control,  properly  insured,  until  Buyer  and  Company 
provided  sufiEicient  funds  to  release  them  and  meet  the  draft  at 
the  expiration  of  60  days. 

To  accomplish  the  transfer  of  the  merchandise  from  the  rail- 
road to  the  warehouse,  it  would  have  been  necessary  for  the  bank 
to  surrender  the  shipping  documents  to  its  customer  on  a  trust 
receipt,  which  would  be  temporarily  accepted  pending  the  de- 
livery of  the  warehouse  receipt.  However,  the  bank  may,  if  it 
chooses,  grant  Buyer  and  Company  more  liberal  terms  by  sur- 
rendering the  documents  to  them  without  requiring  any  col- 
lateral security  and  the  acceptance  would  comply  with  the 
Federal  Reserve  Act  and  be  eligible  for  rediscount. 

4.  Diagrammatical  Representation. — The  diagram  in  Form 
19  illustrates  the  financing  of  the  shipment  in  the  example  con- 
sidered above.  Each  step  is  numbered  in  order  and  the  explana- 
tion of  the  several  steps  is  as  follows : 

1.  Buj'cr  and  Company  arrange  with  their  New  York  bank  (.1)  to 
open  a  60  days'  acceptance  credit  in  favor  of  Seller  and  Company  of  St. 
Louis. 

2.  Buyer  and  Company's  New  York  bank  (A)  forwards  to  Seller  and 
Company  a  domestic  letter  of  credit  authorizing  drafts  for  not  more  than 
a  specified  sum,  say,  $65,000,  when  drawn  at  60  days'  sight  and  accom- 
panied by  bill  of  lading  and  insurance  certificates. 

3.  Having  arranged  shipping  details  and  having  provided  for  insurance, 
Seller  and  Company  draw  a  draft  on  the  New  Yoik  bank  (A)  at  60  days' 
sight  for  the  amount  of  the  shipment,  say,  $64,898.50,  and  attach  to  it 
their  own  invoice,  original  bill  of  lading,  and  insurance  certificates.    The 


360 


BANKING  AND  CREDIT 


XXVI 


draft  with  documents  is  then  turned  over  by  Seller  and  Company  to  their 
St.  Louis  bank  (C)  for  collection. 

Insteadof  receiving  the  item  for  collection  the  St.  Louis  bank  (C)  might 
have  purchased  (discounted)  it.  If  this  were  done  the  St.  Louis  bank  (C) 
would  immediately  forward  the  item  to  its  New  York  correspondent  (B) 


Seller  and  Company 
St.  Louis 


Seller  and  Company's 

St.Louis  Bank 

BankC 


Buyer  and  Company 
New  York 


(6a) 


Buyer  and  Company's 

New  York  Bank 

Bank  A 


(6) 


New  York 

Correspondent 

of  St.Louis  Bank 

Bank  B 


New  York 
Discount  House 
(Open  Market) 


Form  19. 


Diagram  Illustrating  the  Financing  of  a  Shipment  of  Goods  by 
Means  of  Bankers'  Acceptances 


with  instructions  that  the  draft  be  presented  for  acceptance  and  then  held 
until  maturity  for  payment,  or  sold  in  the  New  York  market,  the  proceeds 
being  placed  to  the  credit  of  the  St.  Louis  bank,  or  returned  to  St.  Louis. 
Many  banks  offer  to  market  bills  on  behalf  of  their  customers,  the  chief 
reason  being  that  a  bank  actively  engaged  in  acceptance  business  has 
better  access  to  the  discount  market  and  closer  familiarity  with  houses 
offering  the  best  rate  and  having  the  widest  distribution  for  bills  than  is 
possible  for  the  individual  merchant. 

4.  The  St.  Louis  bank  (C)  forwards  the  draft  with  documents  to  its 
correspondent  bank  in  New  York  (B). 


XXVI  ]  ACCEPTANCES  361 

5.  The  New  York  correspondent  (B)  of  the  St.  Louis  bank  presents 
the  draft  with  documents  to  the  drawee  bank  (.4),  that  is,  Buyer  and 
Company's  bank,  for  acceptance. 

6.  After  having  accepted  the  draft  the  drawee  bank  (A)  retains  the 
documents  but  returns  the  draft  itself  to  presenting  bank  (5),  that  is,  the 
correspondent  of  the  St.  Louis  bank. 

6a.  In  accordance  with  customary  arrangements  the  shipping  docu- 
ments are  released  to  Buyer  and  Company  by  their  bank  (.1)  under  a 
trust  receipt.  Buyer  and  Company  surrender  the  bill  of  lading  to  the  rail- 
road company  and  obtain  the  goods.  In  some  cases  banks,  upon  delivery 
of  bills  of  lading  or  other  evidences  of  property  held  to  secure  payment 
of  the  bill,  demand  some  sort  of  collateral  to  be  held  by  the  bank  pending 
the  removal  from  the  warehouse  or  railroad  and  sale  of  merchandise 
described  in  the  bill  of  lading.  But  if  a  customer  is  of  undoubted  credit 
standing  and  well  known  to  the  bank  holding  the  documents,  the  use  of  a 
trust  receipt  or  collateral  is  waived. 

7.  The  New  York  bank  (B),  upon  order  from  its  St.  Louis  correspon- 
dent, sells  the  acceptance  for  the  latter's  account  in  the  New  York  market. 

5.  Wide  Use  of  Bankers'  Acceptances.^Under  the  Federal 
Reserve  Act  the  use  of  bankers'  domestic  acceptances  is  not  re- 
stricted to  transactions  based  on  an  actual  sale  and  shipment  of 
goods;  banks  are  permitted  to  accept  drafts  secured  by  ware- 
house receipts  or  other  documents  conveying  or  securing  title 
covering  readily  marketable  staples.  In  different  sections  of  the 
country  during  the  crop-moving  periods  there  is  a  greater  local 
demand  for  money  than  the  immediate  available  supply  in  that 
region.  At  the  same  time  there  are,  very  likely,  banks  in  other 
districts  which  have  surplus  funds  awaiting  investment.  For 
the  purpose  of  drawing  upon  these  surplus  funds  and  equalizing 
the  interest  rates  between  different  sections  of  the  country,  the 
Federal  Reserve  Act  provides  a  simple  but  effective  means. 

Suppose  a  southern  cotton-buyer  has  requested  his  bank  in 
Dallas  to  help  him  finance  some  cotton  which  he  has  in  storage 
awaiting  shipment.  Furthermore,  assume  that  the  Dallas  bank 
has  loaned  all  of  its  available  money  and  therefore  is  not  in  a 
Dosition  to  advance  any  funds  to  its  client  on  the  basis  of  his 


362  BANKING  AND  CREDIT  [  XXVI 

promissory  note,  receivables,  or  other  paper.  The  bank  may, 
however,  loan  the  cotton-buyer  its  credit,  that  is,  agree  to  accept 
drafts  drawn  upon  it  when  they  are  secured  by  the  proper  ware- 
house receipts  and  insurance  papers.  Upon  acceptance  this 
instrument  can  be  readily  sold  to  bankers  in  other  parts  of  the 
country  who  happen  to  have  surplus  funds  at  their  disposal. 

Although  bankers'  acceptances  occupy  a  prominent  place  in 
domestic  transactions,  they  play  a  role  of  greater  importance  in 
financing  imports  and  exports.  Under  the  federal  reserve  regu- 
lations, bills  drawn  under  a  credit  opened  for  the  purpose  of 
conducting  or  settling  accounts  resulting  from  a  transaction  or 
transactions  involving  the  shipment  of  goods  between  the  United 
States  and  any  foreign  country  or  between  the  United  States  and 
any  of  its  dependencies  or  insular  possessions  or  between  foreign 
countries,  are  eligible  for  rediscount.  Any  federal  reserve  bank 
may  also  acquire  drafts  or  bills  drawn  by  a  bank  or  banker  in  a 
foreign  country  or  dependency,  or  insular  possession  of  the 
United  States  for  the  purpose  of  furnishing  dollar  exchange  under 
prescribed  conditions. 

The  extensive  use  of  bankers'  acceptances  in  financing  im- 
ports and  exports  is  indicated  by  the  large  number  of  American 
branch  banks  and  agencies  which  have  been  opened  in  foreign 
lands  since  the  passage  of  the  Federal  Reserve  Act.  An  idea  of 
the  importance  of  the  dollar  acceptance  and  "dollar  exchange" 
is  to  be  gained  from  a  statement  of  Paul  M.  Warburg: 

There  are  outstanding  today  (June  lo,  1919),  drawn  in  almost 
every  part  of  the  globe,  approximately  $500,000,000  in  American 
bankers'  acceptances.  But  this  is  only  the  beginning.  Some 
months  ago  I  ventured  the  prediction  that  in  the  not  too  distant 
future  we  should  live  to  see  American  bankers'  acceptances  reach 
the  billion  dollar  mark,  and  I  have  no  hesitation  in  reafifirming  the 
opinion. 

6.  Necessity  of  Bankers'  Acceptances  for  a  Discount  Market. 

— Before  the  inauguration  of  the  federal  reserve  system  in  1914 


XXVI  ]  ACCEPTANCES  363 

our  banking  system  lacked  a  standardized  credit  instrument 
and  this  made  a  broad  discount  market  an  impossibility.  If  we 
had  no  well-defined  methods  of  grading  cotton,  dealings  on  the 
Cotton  Exchange  would  be  very  limited  if  at  all  possible.  The 
same  holds  true  in  the  case  of  tobacco,  grain,  wool,  and  many 
other  commodities.  The  bank  acceptance  is  a  credit  instrument 
in  which  the  element  of  risk  has  been  reduced  to  a  negligible 
factor  because  direct  responsibility  for  its  payment  rests  on  bank- 
ing institutions  whose  standing  is  generally  well  known.  In 
order  to  throw  light  upon  the  importance  of  bank  acceptances  in 
this  connection,  it  is  helpful  to  consider  rather  briefly  the  prin- 
cipal functions  and  features  of  a  discount  market. 

The  most  important  function  of  a  discount  market  is  to  fur- 
nish a  central  reservoir  of  commercial  credit  by  means  of  which 
individual  banks  may  regulate  their  investment  and  cash  posi- 
tion. A  broad  discount  market  operates  as  an  equalizer  of  in- 
terest rates  not  only  between  different  sections  of  the  country 
but  also  between  the  United  States  and  foreign  countries.  For 
instance,  if  banks  in  one  district  have  surplus  funds,  their  pur- 
chases of  acceptances  in  the  discount  market  will  tend  to  raise 
interest  rates  in  that  district  to  the  level  in  other  districts.  Simi- 
larly in  the  case  of  the  United  States  and  foreign  countries,  the 
purchase  or  sale  of  bills  moves  funds  from  countries  where  in- 
terest rates  are  low  to  those  where  interest  rates  are  high.  It  is 
understood,  of  course,  that  to  some  extent  inequalities  will  con- 
tinue to  exist  even  within  a  country  on  account  of  lack  of  com- 
plete mobihty  of  banking  funds  and  minor  differences  in  risk. 

A  broad  discount  market  also  tends  to  stabilize  gold  move- 
ments between  countries.  In  the  past  gold  was  frequently 
exported  or  imported  when  it  was  clearly  foreseen  that  existing 
conditions  were  but  temporary.  By  making  it  possible  for  banks 
to  accumulate  in  their  portfolios  supplies  of  foreign  bills  and  to 
sell  them  when  the  market  conditions  are  favorable  for  making 
a  profit,  many  unnecessary  gold  shipments  can  be  prevented. 


364  BANKING  AND  CREDIT  [  XXVI 

The  prevention  of  unnecessary  gold  movements  and  the  de- 
velopment of  a  closer  relation  between  interest  rates  here  and 
abroad  tends  to  produce  greater  stability  of  interest  rates  within 
the  United  States.  This  is  mainly  due  to  the  fact  that  large 
reservoirs  of  credit  are  not  subject  to  sudden  movements  in  the 
same  measure  that  smaller  ones  are. 

The  component  factors  of  a  discount  market  are: 

1.  The  banks  that  create  the  acceptance. 

2.  The  banks  and  others  who  purchase   and   sell   accept- 

ances. 

3.  The  central  bank  of  rediscount  (in  the  United  States  the 

1 2  federal  reserve  banks) . 

4.  Discount  houses,  brokers,  and  other  middlemen. 

7,  Abuses  of  Bankers*  Acceptances. — In  discussing  certain 
abuses  of  bankers'  acceptances,  Mr.  Warburg  has  stated: 

With  respect  to  bankers'  acceptances,  permit  me  to  give  you 
just  a  few  illustrations:  it  is  clear  that  the  Federal  Reserve  Act 
when  authorizing  domestic  acceptances  contemplated  two  kinds 
of  credits;  one — acceptances  secured  by  readily  marketable 
staples — but  not  to  be  secured  by  any  other  kind  of  goods — and 
two,  credits  to  finance  the  transportation  of  any  kind  of  goods. 
In  both  cases  the  law  prescribes  that  documents — warehouse 
receipts  or  bills  of  lading,  respectively — arc  to  be  attached  when 
the  acceptance  is  made.  Power,  however,  is  given  to  accepting 
banks  to  release  documents  in  order  to  facilitate  the  handling  of 
the  goods.  But  you  can  readily  see  that  abuse  is  possible  by  pre- 
senting documents  at  the  time  the  acceptance  is  made  and  using 
these  documents  over  again,  after  release,  to  secure  another  credit . 
You  can  easily  imagine,  moreover,  how  under  the  guise  of  financ- 
ing a  domestic  transportationjasting  only  a  week  or  two,  a  90-day 
credit  might  be  secured,  which  thus  might  serve  to  carry  articles 
other  than  readily  marketable  staples.  It  is  evident,  furthermore, 
how  easily,  by  this  method,  these  acceptances  may  be  turned  into 
unsecured  transactions;  and  unsecured  credits  amounting  in  the 
aggregate  to  20  per  cent  of  the  capital  and  surplus  of  a  bank  may 


XXVI  ]  ACCEPTANCES  365 

thus  be  granted  to  one  single  party  instead  of  10  per  cent  as  pro- 
vided as  the  hmit  for  similar  loans  under  the  National  Bank  Act. 
Should  the  law  be  amended  so  as  to  prevent  such  abuses,  or 
should  the  federal  reserve  banks  and  the  accepting  banks  get 
together  and  adopt  measures  to  stop  bad  practices  of  their  own 
accord?  I  do  not  think  there  can  be  any  doubt  as  to  which  would 
be  the  better  course. ' 

8.  Trade  Acceptances. — A  trade  acceptance  is  a  bill  of  ex- 
change drawn  to  order,  having  a  definite  maturity  and  payable 
in  dollars  in  the  United  States,  and  bearing  on  its  face  or  accom- 
panied by  satisfactory  evidence  that  it  is  drawn  by  the  seller  of 
the  goods  on  the  purchaser  of  such  goods.  Such  evidence  com- 
monly consists  of  a  statement  on  or  accompanying  the  acceptance 
to  the  following  effect:  "The  obligation  of  the  acceptor  of  this 
bill  arises  out  of  the  purchase  of  goods  from  the  drawer." 

For  the  purpose  of  illustrating  the  use  of  the  trade  acceptance 
let  us  assume  that  a  New  York  firm  called  Buyer  has  purchased 
some  goods  from  a  St.  Louis  firm  called  Seller.  In  rendering  an 
invoice  for  any  single  purchase  that  is  reasonably  large  in  amount, 
Seller  will  send  at  the  same  time  a  trade  acceptance  form  properly 
filled  out.  In  cases  where  Buyer  purchases  several  bills  of  small 
amount,  Seller  when  rendering  a  monthly  statement  will  accom- 
pany the  same  with  a  trade  acceptance  for  the  total  amount. 
Upon  receipt  of  the  trade  acceptance  Buyer  has  the  choice 
of  either  accepting  it  or  paying  the  bill  in  cash.  Should 
he  choose  the  second  plan  he  will  deduct  such  cash  dis- 
count as  is  allowed  under  the  terms  of  transaction  which  have 
been  previously  agreed  on.  On  the  other  hand,  if  Buyer  follows 
the  first  method  he  will  stamp  across  the  face  of  the  trade  ac- 
ceptance the  date  and  the  words  "Accepted,  payable  at  — 
Bank,"  and  then  sign  it  and  return  it  to  Seller.  Seller  may  then 
dispose  of  the  acceptance  in  a  number  of  ways.     He  may  hold  it 


'  Acceptances  in  Our  Domestic  and  International  Commerce,  pamphlet  published  by 
American  Acceptance  Council,  p.  23. 


366  BANKING  AND  CREDIT  [  XXVI 

in  his  portfolio  until  a  few  days  before  it  becomes  due,  when  he 
will  turn  it  over  to  his  bank  for  collection.  If  he  does  not  retain 
the  acceptance  until  then,  he  will  probably  use  it  for  raising  funds 
in  the  meantime  by  selling  it  with  a  number  of  other  trade  ac- 
ceptances to  his  banker  or  in  the  open  market  through  brokers 
or  dealers  in  commercial  paper.  Finally,  as  a  third  possible 
method,  Seller  may  borrow  from  his  bank  on  his  single-name 
promissory  note  and  use  the  acceptance  as  collateral. 

In  reference  to  the  place  of  payment  of  a  trade  acceptance 
the  law  specifies  that  it  shall  be  the  ofBce  of  the  acceptor  (the 
buyer  of  the  goods)  unless  a  different  place  be  designated  on  its  face, 
such  as  the  acceptor's  bank,  and  this  is  the  customary  method. 

Q.  Advantages  of  Trade  Acceptances. — Trade  acceptances 
offer  many  advantages  to  the  banker  and  to  the  buyer  and  seller 
of  the  merchandise.  The  more  important  of  these  advantages 
may  be  summarized  as  follows: 

1.  Trade  acceptances  are  usually  self-liquidating  because 
the  acceptor  receives  certain  merchandise  out  of  which  the  trade 
acceptance  has  arisen  and  from  the  sale  of  these  goods  he  expects 
to  obtain  the  necessary  funds  to  meet  the  obligation  at  maturity. 

2.  When  a  banker  discounts  a  trade  acceptance  he  receives 
two-name  paper,  which  is  generally  safer  than  a  single-name  note. 

3.  When  a  banker  discounts  a  trade  acceptance  he  knows 
from  looking  at  the  face  of  the  instrument  what  the  credit  was 
extended  for,  but  in  the  case  of  a  single-name  note  the  borrower 
makes  it  out  for  a  round  sum  and  may  either  fail  to  state  the  pur- 
pose for  which  the  proceeds  are  to  be  used  or  he  may  explain  his 
object  in  only  a  general  way. 

4.  The  law  providing  against  a  loan  to  any  one  person  of 
more  than  10  per  cent  of  the  capital  and  surplus  of  a  bank  does 
not  apply  to  trade  acceptances. 

5.  Trade  acceptances  as  paper  for  rediscounting  are  looked 
upon  with  particular  favor  by  federal  reserve  banks. 


XXVI  ]  ACCEPTANCES  367 

6.  Secret  assignments  of  book  accounts  for  the  purpose  of 
raising  cash  present  many  objections.  The  use  of  trade  accept- 
ances overcomes  in  a  legitimate  nanner  all  such  disadvantages 
and  leaves  very  little  excuse  for  such  practice. 

7.  Bankers  to  whom  trade  acceptances  are  presented  for  col- 
lection or  for  discount  have  an  opportunity  of  gaining  informa- 
tion in  regard  to  the  credit  standing  and  character  of  those  who 
have  given  acceptances. 

8.  When  trade  acceptances  are  generally  used  and  open  book 
accounts  are  less  common,  bankers  will  be  in  a  position  to  keep 
in  close  touch  with  local  credit  conditions  because  practically 
all  trade  acceptances  are  forwarded  for  collection  through  banks. 

9 .  Whereas  in  the  past  bankers  usually  expected  that  a  borrow- 
er's quick  liabilities  would  not  exceed  50  per  cent  of  his  quick 
assets,  it  is  now  felt  that  the  introduction  of  the  trade  acceptance 
will  make  it  advisable  for  the  50  per  cent  rule  to  be  modified. 

10.  Discount  companies,  brokers  and  other  concerns  in 
the  open  market  provide  a  ready  means  for  disposing  of  such 
paper. 

11.  The  principal  mission  of  the  trade  acceptance,  however, 
is  to  liquify  credit,  improve  merchandise  turnover,  and  minimize 
credit  losses. 

ID.  Objections  to  Use  of  Trade  Acceptances. — Although  the 
foregoing  arguments  might  seem  to  leave  very  little  to  be  said  on 
the  other  side  of  the  case,  nevertheless  many  practical  objections 
have  been  raised  which  those  who  favor  the  use  of  trade  accept- 
ances have  been  unable  to  answer  satisfactorily.  A  number  of 
organizations,  including  the  Philadelphia  Board  of  Trade  and 
the  Commercial  Law  League  of  America,  have  adopted  resolu- 
tions opposing  the  use  of  trade  acceptances.  The  opposing 
arguments  may  be  summarized  as  follows:^ 


'  See  Trade  Acceptances,  Supporting  and  Opposing  Arguments,  pamphlet  published  by 
Chamber  of  Commerce  of  U.  S.  (1918,  Washington). 


368  BANKING  AND  CREDIT  [  XXVI 

1.  Under  existing  commercial  practice  most  trades  in  the 
United  States  have  become  habituated  to  the  cash  discount  sys- 
tem whereby  the  seller  allows  the  buyer  to  deduct  a  certain  per- 
centage from  the  face  of  the  invoice  for  payment  within  a  given 
number  of  days.     Buyers  may  be  divided  into  three  classes: 

First  grade:  Those  who  habitually  discount. 
Second  grade :  Those  who  pay  bills  when  due. 
Third  grade:  Those  who  are  delinquent. 

Naturally,  the  first  grade  of  buyers  will  pay  cash  and  there- 
fore trade  acceptances  will  be  used  for  the  most  part  when  dis- 
counts are  available  only  by  an  inferior  credit  risk  or  a  poor 
business  man. 

2.  Unless  the  seller  has  a  monopoly  or  is  in  a  position  to  prac- 
tically enforce  his  terms  of  sale,  buyers  who  pay  their  bills 
promptly  as  they  mature  will  ordinarily  refuse  to  sign  a  trade 
acceptance,  and,  furthermore,  will  be  antagonized  by  a  request 
to  do  so. 

3.  "The  cash  discount  system  takes  the  burden  of  insuring 
credits  from  the  seller  and  distributes  it  among  thousands  of 
banks  where  buyers  borrow.  It  diminishes  risks,  because  the 
local  banker  can  estimate  better  than  one  at  a  distance  the 
personal  equation  of  the  borrower  and  other  elements  that  enter 
into  the  calculation." 

4.  Whenever  a  merchant  takes  a  trade  acceptance  from  his 
customer  and  discounts  it  at  his  bank,  he  must  indorse  it.  To 
the  extent  of  his  liabihty  as  indorser  the  merchant  is  still  carry- 
ing the  account  as  before.  It  he  adopts  this  plan  generally, 
it  means  that  he  is  an  indorser  for  all  of  his  customers  and 
therefore  contingently  liable  to  the  full  extent  of  their  purchases. 

5.  The  open  account  system  is  more  simple  than  a  system 
which  requires  the  handling  of  a  piece  of  paper,  and  the  indorse- 
ment of  it,  by  the  purchaser  and  seller  of  the  goods  and  the 
lending  bank. 


XXVI  ]  ACCEPTANCES  369 

6.  Under  the  "cash  discount — open  account — single-name 
paper"  system,  payments  are  made  by  the  purchaser  sending 
his  remittance  directly  to  the  seller  in  the  form  of  a  check  which 
may  be  cleared  in  most  cases  without  a  collection  charge.  Trade 
acceptances,  however,  are  more  difficult  to  collect  than  checks 
and  banks  usually  make  a  charge  for  the  service.  In  view  of 
the  objections  that  have  been  raised  trade  acceptances  are  not 
likely  to  gain  rapid  favor  in  many  trades.  The  system  of  open 
accounts,  with  cash  discount  and  single-name  paper,  has  become 
so  strongly  established  in  our  domestic  commerce  that  the  bur- 
den of  proof  will  probably  continue  to  weigh  heavily  on  those 
who  would  replace  this  system  with  another. 

References 

Chamber  of  Commerce  of  the  United  States.  Trade  Acceptances,  Sup- 
porting and  Opposing  Arguments. 

Commercial  Paper  and  Bills  of  Exchange  of  the  World. 
Bank  acceptances,  pp.  37-46. 

Holdsworth,  J.  T.     Money  and  Banking. 

Briefly  summarizes  advantages  of  trade  acceptances,  pp.  110-114. 

Kniffin,  W.  H.     The  Business  Man  and  His  Bank.    pp.  193-212. 

Mathewson,  P.    Acceptances,  Trade  and  Bankers'. 

Gives  a  detailed  description  of  procedure  and  argument  for  use 
of  trade  acceptances  with  illustrations  of  forms. 

Westerfield,  R.  B.     Banking  Principles  and  Practice.     Vol.  IV,  pp.  oqg- 
1020. 

Among  the  banks  and  trust  companies  who  have  published  useful  pam- 
phlets on  acceptances  are  the  Irving  National  Bank,  N.  Y.;  National 
City  Bank  of  New  York;  National  Bank  of  Commerce  in  New  York; 
American  Exchange  National  Bank,  N.  Y.;  Guaranty  Trust  Com- 
pany of  New  York,  N.  Y.;  Mechanics  and  Metals  National  Bank, 
N.  Y.  Useful  pamphlets  have  also  been  prepared  by  the  American 
Acceptance  Council,  iii  Broadway,  N.  Y.  This  organization  also 
publishes  a  monthly  periodical,  Acceptance  Bulletin. 


CHAPTER  XXVII 

PRINCIPLES  OF   FOREIGN  EXCHANGE 

I.  Equilibrium  of  Exchange. — Changes  of  a  fundamental 
character  affecting  our  trade  and  financial  relations  with  other 
countries  were  brought  about  by  the  war.  Previous  to  1914 
the  United  States  occupied  the  position  of  a  borrowing  nation  on 
account  of  large  foreign  investments.  The  vast  untouched  re- 
sources of  our  country  afforded  opportunity  for  cheap  production 
of  foodstuffs  and  raw  materials  of  which  the  European  countries 
particularly  were  in  need.  In  the  earlier  years  of  our  develop- 
ment most  of  the  immigration  from  Europe  was  from  those 
countries  which  were  highly  advanced  in  industrial  methods  and 
which  had  large  accumulations  of  capital.  Under  such  circum- 
stances it  was  a  natural  outcome  that  capital  should  flow  from 
Europe  to  the  United  States  for  investment,  and  that  the  income 
from  this  capital,  unless  reinvested  here,  should  become  a  charge 
against  us  in  the  foreign  exchanges. 

For  some  ten  years  preceding  the  war  the  average  annual 
trade  balance  in  favor  of  the  United  States  on  merchandise  ac- 
count was  approximately  $500,000,000  and  it  was  practically  off- 
set by  what  is  usually  known  as  the  "invisible  account."  That 
is  to  say,  the  United  States  and  other  nations,  like  individuals, 
are  constantly  buying  from  each  other  services  as  well  as  physical 
goods.  To  be  more  exact,  the  figures  upon  which  the  so-called 
favorable  trade  balance  is  based  are  taken  from  the  official  re- 
ports of  the  Department  of  Commerce,  which  show  the  amount  of 
commodities  entered  or  cleared  at  our  various  ports.  But  these 
figures  do  not  contain  any  of  the  invisible  items  of  trade,  such  as 
interest  and  dividend  payments  upon  American  securities  held 
abroad,  commissions  of  foreign  bankers,  premiums  on  policies  of 

370 


XXVII]  PRINCIPLES  OF  FOREIGN  EXCHANGE  371 

foreign  insurance  companies,  charges  of  foreign  shipping  against 
our  merchants,  expenses  of  American  tourists  abroad,  remittances 
of  immigrants  to  relatives  in  the  old  countries,  etc. 

As  a  result  of  the  war  we  have  bought  back  most  of  the 
American  securities  which  were  held  abroad,  and  the  interest 
and  dividends  upon  them  hereafter  will  not  be  a  large  item  for 
settlement  in  international  exchanges.  In  the  future  the  develop- 
ment of  a  large  fleet  of  merchant  ships  will  probably  make  it 
possible  for  us  to  carry  a  greater  portion  of  the  overseas  trade. 
Moreover,  private  and  governmental  loans  to  Europe  have 
suddenly  changed  our  position  from  a  debtor  to  a  creditor  nation. 

The  question  may  be  asked  as  to  what  effect  the  shifting  of 
the  balance  of  payments  in  the  invisible  account  will  have  upon 
our  foreign  trade.  It  is  obvious  that  a  country's  receipts  and 
payments  in  international  commerce  must  balance  in  the  aggre- 
gate. Nothing  changes  hands  except  for  some  equivalent.  A 
country  which  has  borrowed  capital  abroad  must  not  only  pay 
for  all  the  merchandise  that  it  imports  but  must  also  meet  its 
interest  charges.  Normally,  therefore,  a  debtor  nation  exports 
more  merchandise  than  it  imports,  and  a  lending  nation  imports 
more  than  it  exports. 

The  terms  "unfavorable"  and  "favorable"  trade  balances 
arc  misleading.  It  is  customary  to  say  that  the  exchanges  are 
in  our  favor  when  the  dollar  is  at  a  premium  as  measured  in  other 
currencies,  which  is  the  same  thing,  of  course,  as  the  other  cur- 
rencies being  at  a  discount.  The  exchanges  are  in  our  favor  in 
the  sense  that  at  the  time  under  consideration  we  are  exporting 
more  than  we  are  importing  and  that  the  dollar  has  arisen  in 
value  in  the  money  markets  of  the  world.  They  are  in  our  favor 
for  importing  purposes,  but  they  are  not  in  our  favor  for  export- 
ing purposes.  When  dollar  drafts  are  at  a  premium  American 
goods  cost  more  to  foreign  buyers  and  consequently  a  premium 
on  dollar  exchange  operates  in  the  same  way  as  a  tariff  barrier 
abroad. 


372  BANKING  AND  CREDIT  |  XXVII 

2.  Settlement  of  Foreign  Balances. — As  between  individuals 
there  are  only  three  ways  in  which  a  financial  settlement  can  be 
effected.  They  are:  cash,  trade,  and  credit.  As  between  na- 
tions the  situation  is  much  the  same.  Just  as  cash  plays  a  minor 
part  as  compared  with  checks  and  drafts  in  domestic  business, 
gold,  which  is  the  cash  of  international  transactions,  is  used  for 
settling  a  relatively  small  amount  of  the  world's  foreign  trade. 
Even  if  there  had  not  been  developed  the  machinery  of  bills  of 
exchange  and  telegraphic  transfers  for  setthng  international 
transactions,  the  use  of  gold  would  be  limited  for  physical  reasons. 
The  total  amount  of  gold  in  the  world  is  relatively  small  when 
compared  with  the  yearly  volume  of  foreign  trade  of  all  nations. 
To  be  more  exact,  according  to  the  report  of  the  Director  of  the 
Mint  for  1919,  a  conservative  estimate  of  the  world's  gold  mone- 
tary stock  is  $9  billion.  The  total  imports  and  total  exports 
of  the  principal  countries  of  the  world  are  probably  about  six 
times  as  great  as  the  gold  monetary  stock,  or  considerably  more 
than  $50  biUion.' 

Essentially,  foreign  trade  involves  the  exchange  of  goods  and 
not  money.  Naturally,  a  nation  cannot  expect  to  increase  its 
exports  without  reckoning  with  a  corresponding  growth  in  im- 
ports. To  be  sure,  the  extension  of  credit  by  the  selling  nations 
to  the  buying  nations  may  postpone  the  operation  of  this  prin- 
ciple of  reciprocity,  but  ultimately  the  debt  will  be  liquidated 
through  goods  and  not  gold.  A  brief  consideration  at  this  point 
of  the  major  steps  in  the  foreign  banking  operations  required  to 
finance  purchases  and  sales  of  merchandise  abroad  will  be  helpful. 

If  the  London  branch  of  the  Associated  Trust  Company  of 
Boston  collects  £50,000  which  B  in  Leeds  owes  A  in  Boston  for 
shoes,  and  the  bank's  main  office  here  collects  £50,000  which  C 
in  Boston  owes  D  in  Manchester  for  woolens,  it  is  evident  that 
the  shipments  of  merchandise  have  effected  an  exchange  without 


'  See  latest  Statistical  Abstract  of  the  United  States. 


XXVII 1  PRINCIPLES  OF  FOREIGN  EXCHANGE  373 

the  transfer  of  any  cash  or  the  creation  of  any  final  debt.  The 
Boston  bank  debits  its  London  office  for  the  value  of  the  shoes 
and  credits  it  for  the  value  of  the  woolens.  Similarly,  the  Lon- 
don bank  debits  its  Boston  office  for  the  value  of  the  woolens  for 
which  payment  has  been  made  to  D.  and  credits  it  for  the  value 
of  the  shoes.  The  merchants  in  both  countries  have  settled  their 
transactions  in  full;  the  two  branches  of  the  banking  house  are 
square;  and  £100,000  in  business  has  been  consummated  without 
requiring  the  use  of  a  single  coin. 

If  the  shoes  had  amounted  to  £60,000  instead  of  £50,000, 
the  difference  might  have  been  made  up  by  the  Boston  bank 
arranging  to  make  payment  for  a  local  importer  who  had  bought 
£10,000  of  cutlery  from  a  Sheffield  dealer. 

Naturally,  in  actual  practice  it  is  not  to  be  expected  that  pay- 
ments for  merchandise  imports  will  exactly  match  payments  for 
exports.  During  and  following  the  war  the  exports  of  the  United 
States  exceeded  the  imports,  causing  a  heavy  foreign  credit  bal- 
ance in  our  favor  to  be  estabHshed.  From  time  to  time  this 
balance  was  reduced  by  shipments  of  gold  to  this  country  and  by 
our  extension  of  large  credits  to  foreign  countries.  It  is  not  to  be 
assumed,  however,  that  this  situation  alters  the  truth  of  the 
undisputed  economic  principle  of  reciprocity.  According  to  this 
principle  the  total  value  of  the  merchandise  and  services  sold 
by  any  country  to  all  other  countries  must  in  the  long  run  equal 
the  total  value  of  the  merchandise  and  services  bought  by  that 
country  from  all  others;  and  the  price-determining  forces  in  the 
world's  markets  automatically  check  the  continued  flow  of  money 
into  or  from  any  country. 

3.  What  Foreign  Exchange  Is. — "Foreign  exchange,"  as  the 
term  is  commonly  employed,  covers  in  its  broadest  sense  all  the 
variety  of  monetary  and  credit  instruments  used  in  the  settle- 
ment of  international  transactions.  It  includes  bills  of  exchange, 
cable  transfers,  gold,  silver,  currency,  international  money-orders, 


374  BANKING  AND  CREDIT  [  XXVII 

international  reply  coupons,  travelers'  checks,   stocks,   bonds, 
bond  coupons,  and  interest  and  dividend  checks. 

Just  as  the  check  is  the  most  common  instrument  for  making 
domestic  payments,  the  foreign  bill  of  exchange  is  the  principal 
medium  for  settling  debts  between  the  business  men  of  one 
country  and  those  of  another.  Foreign  bills  of  exchange  are 
similar  to  domestic  drafts  and  are  simply  written  orders  drawn 
by  one  person  upon  a  second  and  made  payable  to  a  third  party, 
or  possibly  to  the  drawer  himself.  Below  is  an  example  of  bill 
drawn  by  a  merchant  in  the  United  States  upon  a  London  bank: 

£800  New  York,  N.  Y.,  December  20,  1921. 

Sixty  days  after  sight  of  this  First  of  Exchange 

(Second  of  the  same  tenor  an,d  date  unpaid)  pay  to  the  order  of  ourselves  eight 

hundred  pounds. 

For  value  received  and  charge  to  account  of 

To  London  and  Liverpool  Bank,  Ltd.  Merchants  Export  Company 

London,  E.  C,  England.  Sherman  Noyes 

No.  165  Treasurer 

4.  Classification  of  Foreign  Bills  of  Exchange. — Foreign  bills 
of  exchange  may  be  classified  in  a  number  of  ways: 

1.  As  to  maturity: 

(a)  Demand  or  sight   bills  or  bankers'   checks — payable  im- 

mediately on  presentation. 

(b)  Short  bills — payable  within  a  month  from  time  of  accept- 

ance. 

(c)  Long  bills — payable  after  a  month  from  time  of  acceptance. 

2.  As  to  whether  drawn  payable  after  sight  or  after  date: 

(a)  Drawn  payable  so  many  days  after  sight,  that  is,  after 

acceptance. 

(b)  Drawn  payable  so  many  days  after  date  (not  common  in 

foreign  exchange). 

3.  As  to  domicile: 

(a)  Sterling  drafts,  also  called  "sterling  exchange" — payable  in 

pounds  in  England. 

(b)  Franc  drafts — payable  in  francs  in  France. 


XXVII  ]  PRINCIPLES  OF  FOREIGN  EXCHANGE  375 

(c)  Dollar  drafts,   also   called   "dollar  exchange,"  or  "dollar 

acceptances" — payable  in  dollars  in  United  States. 

(d)  Bills  on  other  countries. 

4.  As  to  whether  bearing  collateral  security  or  not: 

(a)  Documentary  bills — having  attached   bills  of  lading  and 

other  shipping  papers. 

(b)  Clean  bills — with  no  documents  attached. 

5.  As  to  parties  to  instrument: 

(a)  Bankers'  bills,  bankers'  drafts  or  bankers'  checks — drawn 

by  one  bank  against  another. 

(b)  Commercial  bills — drawn  by  a  merchant  against  another 

merchant  or  the  latter's  bank. 

6.  As  to  nature  of  transaction: 

(a)  Grain  bills. 

(b)  Cotton  bills. 

(c)  Finance  bills — drawn  for  purpose  of  borrowing  funds  in 

foreign  money  markets. 

5.  Foreign  Exchange  Markets. — International  trade,  like 
domestic  trade,  has  created  certain  important  money  markets 
where  the  great  bulk  of  exchange  transactions  are  handled.  By 
maintaining  balances  at  these  points  banks  in  other  parts  of  the 
world  can  sell  drafts,  or  the  right  to  draw  them,  to  persons  who 
wish  to  make  payments  abroad. 

In  order  to  build  up  these  balances  with  foreign  correspond- 
ents, local  banks  must  buy  for  remittance  bills  of  exchange  or 
other  foreign  items  from  customers  or  from  other  banks.  Briefly, 
therefore,  the  foreign  exchange  transactions  of  a  bank  are  for  the 
most  part  connected  with  the  hundred  and  one  operations  neces- 
sitated in  the  buying  of  commercial  bills  from  one  set  of  customers 
for  foreign  remittance,  and  the  selling  to  another  set  of  customers 
drafts  drawn  against  the  proceeds  obtained  abroad.  Of  impor- 
tance also  are  dealings  of  a  bank  to  cover  its  position  in  the 
market  so  that  speculative  losses  may  be  avoided. 

Before  the  war  London,  by  occupying  much  the  same  posi- 
tion with  respect  to  the  commerce  of  the  world  as  New  York 


376  BANKING  AND  CREDIT  [XXVII 

holds  in  the  trade  of  the  United  States,  was  the  leading  inter- 
national money  market,  and  sterling  exchange  was  looked  upon 
as  the  international  money  par  excellence.  During  recent  years 
the  wide  fluctuations  in  sterling  drafts  have  increased  the  element 
of  risk  involved  in  settlements  through  London  and  have  caused 
dollar  acceptances  to  enjoy  greater  favor  than  previously, 
particularly  with  American  business  houses. 

6.  Dollar  Exchange. — Until  after  the  passage  of  the  Federal 
Reserve  Act  in  19 13  national  banks  were  not  permitted  to  accept 
time  drafts  drawn  against  them.  It  became  the  customary 
practice  for  exporters  in  other  countries  who  were  sending  goods 
to  the  United  States  to  draw  their  drafts  against  credits  opened 
by  American  importers  in  London,  Paris,  or  some  other  foreign 
center.  Occasionally,  however,  drafts  were  drawn  on  the  Ameri- 
can importer  himself,  but  unless  the  latter  had  an  international 
reputation  his  acceptances  did  not  find  a  ready  discount  market 
abroad  and  consequently  were  not  a  desirable  form  of  settlement 
to  the  foreigner.  At  present  member  banks  in  the  federal  re- 
serve system  are  authorized  to  accept  drafts  drawn  against  them 
which  have  not  more  than  6  months'  sight  to  run,  resulting  from 
transactions  involving  the  importation  or  exportation  of  goods. 
The  law  also  permits  member  banks  to  accept  dollar  drafts  that 
are  not  connected  with  the  specific  shipment  of  merchandise,  but 
which  are  drawn  by  banks  or  bankers^  for  the  purpose  of  trans- 
ferring funds  for  any  legitimate  object  as  required  by  the  usages 
of  trade  in  the  countries  of  their  origin.  This  provision  enables 
American  banks  to  make  convenient  arrangements  to  maintain 
balances  abroad  and  foreign  banks  to  do  the  same  thing  in  the 
United  States. 

Another  factor  contributing  to  the  development  of  the  use 
of  dollar  exchange  is  the  authority  granted  to  American  banks  to 


^  Individual  merchants  may  not  draw  dollar  exchange  of  this  second  class;  the  drawer 
must  be  a  bank  or  banker. 


XXVII]  PRINCIPLES  OF  FOREIGN  EXCHANGE  377 

establish  foreign  branches.  Particularly,  many  of  the  large  banks 
located  at  the  seaboard  have  taken  advantage  of  this  provision 
and  have  opened  branches  in  the  principal  foreign  banking 
centers. 

7.  Par  of  Exchange. — To  explain  the  movements  of  exchange 
rates  in  a  simple  manner  was  never  an  easy  matter  and  the  erratic 
fluctuations  brought  on  by  the  war  have  not  been  conducive  to 
greater  simplicity  of  the  task.  A  convenient  rule-of- thumb  to 
remember  is  that  whenever  the  United  States  becomes  indebted 
to  another  country,  whether  it  be  for  merchandise  purchased  or  on 
account  of  freight,  insurance,  or  other  charges  against  us,  a  de- 
mand is  created  for  foreign  exchange  in  this  country  in  order  to 
transfer  funds  abroad,  thus  tending  to  cause  the  rates  to  advance. 
Similarly  whenever  a  foreign  country  becomes  indebted  to  us  for 
any  reason,  funds  must  be  transferred  in  our  direction,  thus  in- 
creasing the  supply  of  foreign  exchange  available  for  sale  in  the 
United  States  and  therefore  tending  to  cause  the  exchange  rate 
to  decline. 

The  rates  of  exchange  are  in  the  first  instance  determined  by 
the  intrinsic  relation  of  the  monetary  unit  of  one  country  with 
that  of  another  country.  For  example,  the  gold  sovereign  con- 
tains 113.002  grains  of  pure  gold,  and  is  therefore  4.8665  times 
the  amount  of  pure  gold  contained  in  the  gold  dollar,  which  is 
not  coined  but  amounts  to  i/io  of  the  pure  bullion  contents  of 
the  $10  gold  piece  (232.2  grains).  This  relation  between  the 
monetary  units  of  two  countries,  which  is  found  in  the  case  of 
countries  on  a  gold  basis  by  comparing  the  pure  bullion  contents 
of  the  units  in  question,  is  called  the  "par  of  exchange." 
Just  as  $4.8665  is  found  to  be  the  par  of  exchange  between  the 
United  States  and  England,  the  par  of  exchange  between  the 
United  States  and  France  is  $.1930,  between  the  United  States 
and  Germany  $.2382,  etc.  Between  countries  on  a  gold  basis, 
par  of  exchange  is  invariable  as  long  as  the  pure  bullion  contents 


378  BANKING  AND  CREDIT  [  XXVII 

of  the  coins  being  compared  remain  unchanged,  or,  in  other 
words,  until  one  of  the  countries  in  question  adopts  a  new  coinage 
law. 

In  the  case  where  one  country  is  on  a  silver  basis  and  the  other 
is  on  a  gold  basis,  a  momentary  par  of  exchange  is  found  by  com- 
paring the  market  value  of  the  pure  bullion  contents  of  the  re- 
spective coins.  Naturally,  the  par  of  exchange  between  the 
United  States  and  China  will  be  different  when  silver  is  quoted 
at  90  cents  per  ounce  than  when  it  is  quoted  at  75  cents  an  ounce. 

8.  Movements  Above  and  Below  Par. — If  it  cost  nothing 
either  in  the  way  of  transportation  or  interest  charges  to  ship 
gold  between  two  countries  on  a  gold  basis  and  there  were  a  per- 
fectly free  gold  market  at  both  ends  (that  is,  if  there  were  no 
restrictions  on  gold  exports  and  the  paper  money  in  each  country 
was  convertible  into  gold),  the  rate  of  exchange  would  always  be 
at  par.  Let  us  consider  the  exchange  between  the  United  States 
and  England  before  the  war.  At  that  time  England  was  not  on 
an  inconvertible  paper  basis  as  at  present  (1922)  and  it  was  pos- 
sible for  a  person  holding  a  pound  sterling  note  or  demand  draft 
to  convert  it  immediately  at  face  value  into  gold  sovereigns. 
Furthermore,  there  were  no  governmental  restrictions  on  export 
shipments  of  gold  from  that  country.  Under  these  conditions 
the  holder  of  a  sterling  demand  draft  in  the  United  States  would 
not  sell  it  for  any  sum  less  than  the  equivalent  in  United  States 
money  of  the  sum  due  in  England  after  deducting  the  cost  of 
sending  the  gold  to  this  country,  because  with  the  British  gold 
the  American  could  obtain  at  the  mint  or  in  the  market  our 
money  at  the  ratio  of  $4.8665  for  i  sovereign.  Similarly,  an 
importer  in  the  United  States  who  wished  to  remit  funds  to  Great 
Britain  would  have  the  choice  of  shipping  actual  gold  in  case 
the  exchange  rate  went  far  enough  above  par  (before  the  war 
about  2  1/2  cents  per  sovereign)  to  make  it  profitable.  The 
rates  above  and  below  par  at  which  gold  shipments  take  place 


XXVII]  PRINCIPLES  OF  FOREIGN  EXCHANGE  379 

are  called  the  "upper"  and  "lower"  gold  points;  they  are  not 
absolute  but  vary  from  time  to  time  as  shipping  costs  decrease 
or  increase. 

9.  Effect  of  Depreciated  Paper  Money. — The  stabilizing  in- 
fluence on  the  exchange  rates  that  was  produced  before  the  war 
by  unrestricted  gold  shipments  disappeared  shortly  after  the 
outbreak  of  hostilities,  when  the  principal  European  countries 
took  measures  to  protect  their  gold  reserves.  Gold  disappeared 
from  circulation  and  these  countries,  by  suspending  the  redemp- 
tion of  paper  money  in  gold  coin,  automatically  changed  from  a 
gold  to  an  inconvertible  paper  basis.  In  determining  the  rates  of 
exchange  between  the  United  States  and  England  or  France  or 
Italy,  the  original  par  of  exchange  in  each  case  began  to  exert  a 
smaller  and  smaller  influence  as  these  countries  increased  their 
issues  of  paper  money  and  thus  departed  farther  and  farther  from 
their  gold  bases. 

Paper  money  is  a  promise  to  pay  on  demand  basic  or  stand- 
ard money.  Basic  or  standard  money  in  the  United  States  and 
Europe  is  a  piece  of  gold  bearing  the  stamp  of  the  issuing  govern- 
ment. The  stamp  is  primarily  a  certification  of  weight  and 
fineness  and  has  no  other  commercial  significance ;  in  international 
money  transactions,  gold  exchanges  according  to  its  weight  and 
fineness.  So  long  as  a  nation  keeps  its  promise  to  pay,  on  demand, 
gold  for  paper  money  the  latter  remains  at  parity  with  gold. 
When  the  promise  is  suspended,  however,  gold  is  driven  out  of 
circulation,  prices  in  general  are  quoted  in  the  paper  money,  and 
gold  money  commands  a  premium.  If  it  is  expected  that  gold 
payments  will  not  be  resumed  in  a  short  time,  the  premium  will 
be  large.  Obviously  the  quantity  of  paper  money  outstanding 
will  be  an  important  factor  influencing  this  situation.  At  any 
given  time  the  value  of  such  paper  money  is  affected  by  every 
rumor  which  has  to  do  with  the  credit  of  the  issuing  government. 
Thus  during  the  Civil  War  the  price  of  gold  in  terms  of  green- 


38o  BANKING  AND  CREDIT  [XXVII 

backs  rose  and  fell  according  to  whether  final  victory  seemed  to 
favor  the  Union  or  Confederate  armies.  But,  what  is  still  more 
pertinent  to  the  present  problem,  the  price  of  gold  and  the  price 
of  sterling  exchange  moved  very  closely  together  in  New  York 
from  1862  to  1879,  when  greenbacks  finally  came  to  par  with 
gold. 

Without  the  stabilizing  influence  of  unrestricted  gold  ship- 
ments, exchange  rates  become  speculative  and  may  conceivably 
fluctuate  within  almost  any  limits.  The  rate  or  price  at  any 
time  is  determined,  like  the  price  of  commodities,  by  the  forces 
of  supply  and  demand.  But  the  character  of  the  supply  and 
demand  depends  not  only  upon  the  industrial  and  financial  con- 
ditions of  the  countries  under  consideration,  but  it  is  also  af- 
fected by  all  kinds  of  rumors,  such  as  concerning  plans  for  grant- 
ing large  credits  by  the  United  States,  internal  difficulties,  etc. 
All  those  things  which  tend  to  contribute  toward  the  greater 
economic  production  of  European  countries  will  make  possible 
larger  exports  by  them,  and  thus,  through  increasing  their  credits 
in  the  foreign  exchanges,  will  tend  to  bolster  their  exchange  rates. 
Practically  speaking,  it  is  difficult  to  conceive  how  foreign  ex- 
change rates  on  Europe  can  be  brought  back  to  par  until  it  is 
evident  that  these  countries  will  shortly  resume  specie  payments 
and  make  their  paper  money  redeemable  in  gold  at  100  per  cent 
face  value.  Otherwise,  even  if  the  unfavorable  trade  balances 
against  European  countries  were  corrected,  their  exchanges  would 
still  be  depreciated  to  the  extent  that  their  currency  is  depre- 
ciated internally.  Naturally,  this  necessitates  greatly  improved 
economic  conditions — the  restoration  of  the  normal  methods  of 
international  trade  by  which  goods  are  used  to  pay  for  goods,  and 
the  resumption  finally  of  specie  payments. 

10.  "Pegging"  Exchange. — It  is  not  to  be  assumed  that 
foreign  exchange  rates  are  determined  solely  by  commercial  and 
banking  factors.     This  would  be  the  practical  situation  if  we  were 


XXVII  1  PRINCIPLES  OF  FOREIGxN  EXCHANGE  381 

living  in  a  laissez-faire  regime;  but  particularly  since  the  war 
movements  of  gold,  interest  rates  and  exchange  rates  have  been 
subject  to  influences  outside  the  free  operation  of  the  law  of  sup- 
ply and  demand.  Governments  exerting  their  influences 
through  central  banks  and  other  channels  adjust  discount  rates, 
borrow  funds,  and  buy  and  sell  gold,  silver,  and  securities  in  such 
manner  as  to  affect  very  decidedly  the  foreign  exchanges. 

During  the  latter  part  of  the  war  the  English,  French,  and 
Italian  exchanges  were  "pegged,"  or  fixed  by  agreement  at  a 
point  somewhat  below  par,  called  the  "war  par."  For  instance, 
the  rate  of  sterling  exchange  in  the  New  York  market  was  fixed 
by  the  British  government  at  $4.76  7/'i6  from  January,  1916, 
until  March,  1919,  by  authorizing  J.  P.  Morgan  and  Company 
to  buy  bills  that  might  be  offered  in  New  York  at  that  rate. 
When  the  plan  was  suspended  a  sharp  decline  in  sterling  followed. 
It  was  explained  by  some  persons  that  by  permitting  British 
bills  to  decline  to  a  point  where  remittances  were  made  extremely 
costly  to  the  English  business  man,  purchases  in  the  United 
States  for  import  into  Great  Britain  would  be  curtailed.  This 
was  bound  to  be  a  result;  but  whether  it  was  the  primary  reason 
for  the  action  taken,  or  whether  some  other  motive  was  responsi- 
ble, the  official  "pegging"  policy  would  under  any  circumstances 
have  had  to  be  abandoned  sooner  or  later  on  account  of  the  in- 
ability of  the  British  government  to  continue  indefinitely  to 
furnish  J.  P.  Morgan  and  Company  with  funds  to  meet  its 
commitments. 

II.  Spread  in  Rates. — Fundamentally,  the  spread  in 
rates  between  drafts  payable  at  different  dates  is  a  function  of  time 
and  interest.  As  might  be  expected,  demand  drafts,  which  are 
payable  immediately  upon  presentation  to  the  debtor  or  drawee, 
will  command  a  higher  price  than  time  bills,  which  need  not  be 
paid  until  a  stated  period  of  time  has  elapsed.  But  since  the 
quickest  way  of  remitting  funds  abroad  is  by  cable,  telegraphic 


382  BANKING  AND  CREDIT  [XXVII 

transfer  rates  will  be  higher  in  price  than  quotations  for  demand 
drafts. 

Raising  and  lowering  of  the  discount  and  interest  rates  abroad 
have  an  important  influence  on  the  rates  of  foreign  exchange  in 
American  financial  centers.  To  illustrate  the  point,  let  us  as- 
sume that  an  American  exporter  has  requested  his  New  York 
banker  to  purchase  a  6o-day  sterling  bill  on  a  London  bank. 
The  rate  that  the  New  York  banker  can  offer  for  the  bill  will  de- 
pend on  the  proceeds  he  expects  to  be  able  to  realize  from  mailing 
the  item  to  a  London  correspondent  for  discount  and  credit,  and 
selling  against  this  credit  demand  drafts  in  this  country.  Neces- 
sarily with  a  high  London  discount  rate  the  proceeds  of  the  60- 
day  bill,  and  consequently  the  sterling  rate  for  it  in  New  York, 
will  be  less  than  if  the  London  discount  charges  were  low.  In 
the  case  of  demand  drafts  the  effect,  if  any,  of  a  change  in  the 
London  or  other  foreign  discount  rates  is  more  limited  but 
quite  the  opposite  to  that  produced  upon  time  bills.  This  is 
because  higher  interest  rates  abroad,  if  continued  for  any  con- 
siderable period  without  a  corresponding  change  in  this  country, 
will  tend  to  cause  American  banks  to  loan  more  funds  in  foreign 
money  markets  and  to  withdraw  less  through  the  sale  of  demand 
drafts  here.  Not  only  will  the  supply  of  demand  drafts  thus  be 
curtailed  but  there  might  be  expected  also  in  some  cases  an  in- 
creased buying  of  demand  drafts  in  this  country  for  the  purpose 
of  remitting  funds  abroad  to  be  loaned  there. 

12.  Rate  Adjustment.— If  for  any  reason  the  rates  should  get 
"out-of-line,"  there  are  always  persons  ready  to  seize  the  oppor- 
tunity for  profit,  thus  causing  the  situation  to  be  adjusted.  For 
instance,  if  the  rate  in  New  York  for  demand  drafts  on  London 
at  a  certain  time  was  relatively  cheap  as  compared  with  the 
rate  for  cable  transfers,  a  banker  in  this  country  could  buy 
demand  drafts  for  remittance  to  London  and  sell  future  cables 
against    the    prospective   credit.      Another   operation   of   this 


XXVII 1  PRINCIPLES  OF  FOREIGN  EXCHANGE  383 

same   general  nature  is  the  selling  of  demand  drafts  against 
long  bills. 

To  be  more  concrete,  let  us  assume  that  a  New  York  banker 
has  purchased  a  60-day  sight  bill  for  £10,000  drawn  by  an  Ameri- 
can exporter  against  a  bank  credit  opened  in  London  by  an  Eng- 
lish importer.  The  New  York  banker  will  forward  the  draft 
immediately  to  London  and  may  either  instruct  his  correspond- 
ent to  sell  it  in  the  discount  market  and  place  the  proceeds  to  his 
credit  or  to  hold  it  until  maturity.  If  the  instructions  are  that  the 
draft  is  to  be  held  for  maturity,  the  New  York  banker  can  obviate 
the  risk  of  exchange  by  either  selling  futures  (demand  or  cables) 
or  his  own  long  bills  of  about  the  same  maturity.  If,  on  the 
other  hand,  he  chooses  the  plan  of  having  the  bill  discounted,  he 
will  be  able  to  sell  demand  drafts  at  once  against  the  proceeds. 
In  order  to  show  how  this  might  result  in  the  case  mentioned, 
let  us  assume  that  the  pertinent  facts  are  as  follows : 

London  "  arrival "  3  discount  rate  for  60-day  bills 6% 

English  stamp  charges 1/20% 

Rate  for  sterling  demand  drafts  in  New  York 134^' 

Calculation  : 

1.  Amount  of  60-day  bill  on  London £10,000 

2.  Deduct  discount  (63  days'  interest)  at  6% 103. 1 1.3 

3.  Deduct  English  stamp  charges  1/20% 5-  QO 

4.  Proceeds  in  London £  9.^9 J-  ^-9 

5.  Proceeds  in  New  York  from  sale  of  demand  draft  at  $3.40 $33,630.89 

It  is  evident  from  this  calculation  that,  if  the  proceeds  from 
discounting  the  60-day  bill  of  £10,000  and  selling  it  by  way  of  a 
demand  draft  amount  to  $33,630.89,  the  60-day  rate  should  be 
approximately  $3,363  (33,630.89  -^  10,000).  Lack  of  consistency 
in  the  rates  of  these  two  classes  of  bills  would,  of  course,  cause 
bankers  to  buy  the  relatively  cheaper  and  sell  the  relatively  dearer 
until  the  situation  was  adjusted. 

3  London  "arrival"  or  "forward"  discount  rate  means  the  rate  at  which  a  London 
correspondent  bank  will  undertake  to  discount  a  bill  or  parcel  of  bills  "to  arrive,  "  to  use  the 
bankers'  phrase.    The  rate  is  quoted  by  telegraph  in  advance  of  the  shipment  of  bills. 


384  BANKING  AND  CREDIT  [XXVII 

References 


ler,  E.  E.     Organized  Banking. 

International  clearings  and  exchange, , pp.  124-138. 
Brown,  H.  G.    International  Trade  and  Exchange,     pp.  76-102. 
Dunbar,  C.  F.     Theory  and  History  of  Banking,     pp.  103-13 1. 
Escher,  F.     Foreign  Exchange  Explained. 

Technical  explanations  as  well  as  theoretical  analyses. 
Holdsworth,  J.  T.     Money  and  Banking.     Contains  forms,  pp.  256-258. 
Moulton,  H.  G.     Financial  Organization  of  Society.     Part  II,  pp.  107- 

120. 
Phillips,  C.  A.     Readings  in  Money  and  Banking. 

Domestic  exchange,  pp.  290-304;  foreign  exchange,   pp.  305-354. 
Westerfield,  R.  B.     Banking  Principles  and  Practice. 

Comprehensive  explanation  of  the  elements  of  foreign  exchange, 
Vol.  V,  pp.  1096-1173. 
Whitaker,  A.  C.     Foreign  Exchange. 

London  money  market,  pp.  190-257;  purchase  of  bills,  how  rates 
are  determined,  pp.  258-273;  comprehensive  discussion  of  arbitrage, 
pp.  397-428;  specie  shipments,  pp.  517-575- 
Willis,  H.  P.,  and  Edwards,  G.  W.     Banking  and  Business,     pp.  252-269. 
York,  T.     Foreign  Exchange. 

Contains  technical  explanations  as  well  as  theoretical  analyses. 


CHAPTER  XXVIII 

THE  PROCESS   OF  FOREIGN   EXCHANGE 

1.  Foreign  Transactions  of  a  Bank. — The  foreign  transactions 
of  a  bank  have  to  do  principally  with : 

1 .  The  financing  of  merchandise  imports  and  exports. 

2.  The  financing  of  international  sales  and  purchases  of 

securities. 

3.  Interest  and  dividend  remittances. 

4.  The  borrowing  and  loaning  of  funds  abroad. 

5.  The  payment  for  international  services  rendered,  such  as 

freight  and  insurance  or  foreign  travel. 

6.  The  remittances  by  immigrants  of  funds  to  "the  old 

country." 

7.  Dealings  of  a  hedging  or  speculative  character,  as  future 

sales,  options,  and  puts  and  calls. 

A  merchant  has  at  his  disposal  a  number  of  methods  of  financ- 
ing foreign  shipments,  and  for  convenience  the  principal  ones  may 
be  enumerated  as : 

1.  Open  credits. 

2.  Cash  with  order. 

3.  Cash  against  documents. 

4.  Drafts  drawn  under  commercial  letters  of  credit. 

5.  Drafts  drawn  directly  on  the  importer. 

2.  Open  Credits. — By  the  term  "open  credits"  is  meant  the 
usual  book  accounts,  under  which  plan  the  seller,  trusting  in  the 
honesty  and  financial  ability  of  his  customer,  allows  him  to  ob- 
tain merchandise  without  a  documentary  acknowledgment  of  the 
obhgation,  such  as  a  note  or  an  accepted  draft. 

'S  385 


386  BANKING  AND  CREDIT  [XXVIII 

As  far  as  credits  and  financing  are  concerned,  tiie  trade  be- 
tween adjoining  nations  in  Europe  is  handled  in  almost  the  same 
way  as  trade  between  the  various  states  in  this  country.  This 
fact  has  led  to  not  a  little  difficulty  for  many  American  exporters 
selling  their  goods  to  European  buyers  who  have  not  been  accus- 
tomed to  importing  merchandise  from  overseas  and  who  vigor- 
ously object  to  any  other  terms  than  "open  credits."  Merchants 
of  the  West  Indies,  Cuba,  Mexico,  and,  in  short,  of  all  the 
Caribbean  countries,  have  frequently  requested  "open  credits" 
in  dealing  with  foreign  exporters.  Partly  as  a  consequence  of 
the  keen  competition  in  these  fields,  and  partly  because  so  much  of 
the  trade  consists  of  a  direct  exchange  of  imports  and  exports,  a 
large  amount  of  the  business  of  American  export  commission 
houses  with  these  countries  is  carried  on  through  open  credits. 

The  use  of  open  credits  in  international  trade,  particularly 
when  it  is  overseas,  has  some  advantages  but  many  more  disad- 
vantages. The  advantages  consist  principally  of  eliminating  the 
objections  frequently  made  by  foreign  merchants  to  the  purchase 
of  goods  that  are  subject  to  payment  or  acceptance  of  the  draft 
attached  to  the  shipping  documents.  These  objections  are 
usually  based  on  three  grounds:  (i)  unfamiliarity  with  this 
form  of  business;  (2)  that  such  terms  are  a  reflection  on  the  stand- 
ing and  character  of  the  purchaser;  and  (3)  that  the  acceptor  of  a 
draft  becomes  legally  bound  to  pay  at  a  certain  time,  whether  it 
is  convenient  or  not.  Much  has  been  done  and  is  being  done  to 
remove  these  difficulties  and  to  educate  merchants  in  foreign 
trade  to  the  fact  that  drafts  and  acceptances  are  the  universal 
practice  in  all  but  a  very  small  fraction  of  overseas  commerce. 
The  most  convincing  argument,  of  course,  is  the  lower  prices 
which  the  exporter  can  offer  in  case  his  firm  through  the  sale  of  a 
draft  may  obtain  immediate  cash.  Further,  there  may  be 
pointed  out  the  possibility  of  having  the  time  of  payment  of 
drafts  extended  in  case  it  is  not  convenient  for  them  to  be  met 
when  due. 


XXVIII  ]         THE  PROCESS  OF  FOREIGN  EXCHANGE  387 

While  there  are,  no  doubt,  just  as  large,  sound,  or  honest 
business  firms  abroad  as  at  home,  and  although  an  occasional 
exporter  will  be  found  who  will  declare  that  his  experience  in 
extending  open  credits  to  foreign  customers  has  proved  satisfac- 
tory, the  weight  of  evidence  is  against  this  method  of  conducting 
business. 

3.  Cash  with  Order. — A  foreign  importer  is  naturally  reluc- 
tant to  pay  for  his  goods  in  advance.  He  may  not  know  as  much 
about  the  seller  as  the  latter  knows  about  him  and  he  must  be 
convinced  that  the  seller  is  reliable  before  he  will  forward  his 
money.  The  use  of  this  method  of  financing  shipments  is  de- 
cidedly hmited,  particularly  in  the  case  of  an  exporter  who  has 
just  entered  the  field.  The  foreign  merchant  is  mindful  of  in- 
stances of  manufacturers  abroad  receiving,  filing  away,  and  for- 
getting his  orders  to  which  were  attached  bank  drafts  or 
money-orders.  Other  insolvent  concerns  have  used  funds 
remitted  to  them  in  advance  and  have  failed  before  ship- 
ment was  effected,  with  the  result  that  the  unfortunate  for- 
eigners' money  passed  with  the  other  assets  into  the  hands  of 
receivers. 

4.  Cash  against  Documents. — The  term  "cash  against  docu- 
ments" signifies  that  the  importer  will  be  required  to  make  pay- 
ment before  the  shipping  documents,  and  therefore  the  control 
of  the  merchandise,  is  surrendered  to  him.  Although  the  pay- 
ment may  be  made  at  the  point  of  origin,  the  port  of  export  or 
import,  or  the  place  of  destination,  ordinarily  the  place  of  taking 
up  the  documents  is  within  the  exporter's  country.  The  im- 
porter may  provide  for  payment  in  a  number  of  ways :  He  may 
remit  a  draft  payable  in  the  exporter's  country  to  an  agent  who 
will  thus  be  furnished  with  funds  to  take  up  the  documents  for 
him.  He  may  induce  a  commission  house,  located  near  the  ex- 
porter, to  take  up  the  documents  for  him,  in  which  case  there  are 


388  BANKING  AND  CREDIT  IXXVIII 

several  possible  arrangements  between  himself  and  the  commis- 
sion house.  In  the  great  majority  of  cases,  however,  an  arrange- 
ment much  more  satisfactory  than  cash  with  order,  and  one  which 
adequately  protects  both  parties,  is  for  the  buyer  to  open  a 
bank  credit  with  a  responsible  bank  in  some  convenient  foreign 
exchange  center.  The  bank  which  issues  the  credit  may  be 
located  in  the  exporter's  country,  the  importer's  country,  or  in  a 
third  country.  The  institution  which  pays  for  the  documents 
will  reimburse  itself  in  some  appropriate  and  convenient  manner 
at  the  expense  of  the  importer's  bank,  and  the  latter  will  in  turn 
collect  payment  from  the  importer  himself.  The  bankers  will 
of  course  receive  commissions  for  their  services. 

5.  Drafts  Drawn  under  Commercial  Letters  of  Credit. — A 

commercial  letter  of  credit  is  an  authorization  issued  by  a  bank 
in  favor  of  the  seller  and  specifying  the  terms  under  which  he  may 
draw  drafts  on  it  for  what  he  has  sold.  The  letter  of  credit  is 
addressed  to  the  seller  and  it  customarily  begins  with  some  such 
opening  statement  as,  "You  are  hereby  authorized  to  draw 
upon  the  ABC  Bank  under  the  following  conditions."  A  bank 
credit  serves  chiefly  to  give  assurance  to  the  exporter  that  he  will 
be  able  to  sell  his  draft  for  cash  at  the  time  of  shipment.  Where 
the  drawee  bank  and  the  bank  which  grants  the  credit  are  differ- 
ent institutions,  there  frequently  arises  what  is  called  the  "con- 
firmed credit."  Without  confirmation  the  exporter  is  in  the 
beginning  protected  only  by  the  engagement  of  the  bank  which 
has  issued  the  letter  of  credit.  In  the  case  of  a  confirmed  credit 
the  drawee  bank  ratifies  the  original  credit  and  agrees  to  accept 
the  drafts  of  the  exporter;  the  latter  is  thus  given  a  right  of  action 
in  contracts  against  this  bank  in  case  it  should  subsequently 
refuse  to  accept  the  instrument.  After  acceptance,  however,  a 
draft  under  an  unconfirmed  credit  is  just  as  good  as  one  under 
a  confirmed  credit,  because  upon  acceptance  the  drawee  bank 
becomes  fully  and  unconditionally  bound  to  pay. 


XXVIII 1         THE  PROCESS  OF  FOREIGN  EXCHANGE  389 

A  broad  basis  of  classification  of  letters  of  credit  rests  on  the 
right  of  the  issuing  bank  to  rescind  its  engagement  to  honor  drafts 
diawn  by  the  beneficiary.  If  the  credit-issuing  bank  reserves  the 
right  to  withdraw  from  the  undertaking  the  document  is  styled  a 
"revocable"  letter  of  ciedit.  The  "irrevocable"  letter  of  credit 
contains  a  definite  engagement  on  the  part  of  the  issuing  bank  to 
honor  drafts  drawn  by  the  beneficiary  in  accordance  with  the 
terms  and  conditions  specified  in  the  letter.  This  engagement 
may  not  be  cancelled  by  the  issuing  bank  prior  to  the  expiration 
date  without  the  consent  of  the  beneficiary.  The  "irrevocable" 
letter  of  credit  may  be  strengthened  further  by  having  the  notify- 
ing bank  in  the  same  country  as  the  exporter  add  its  unqualified 
assurance  that  it  will  pay  or  accept  the  bills  drawn  by  him  even 
if  the  foreign  bank  should  refuse  to  honor  them.  It  is  then  called 
a  "confirmed"  export  letter  of  credit.  Expressing,  therefore, 
both  the  definite  undertaking  of  the  issuer  and  also  of  the  notifier, 
it  is  actually  an  "irrevocable-confirmed"  letter  of  credit.  Where 
the  notifying  bank  does  not  add  its  guaranty,  the  credit  is 
described  as  "unconfirmed,"  since  the  advising  bank  maintains 
that  it  is  merely  transmitting  the  information  of  the  credit  to 
the  beneficiary  without  incurring  liabihty  for  its  continuance. 
Thus  three  classesof  letters  of  credit  may  exist:  (i)  irrevocable  by 
the  issuer  and  confirmed  by  the  adviser;  (2)  irrevocable  by  the 
issuer  but  unconfirmed  by  the  adviser;  (3)  revocable  by  the  issuer 
and  also  unconfirmed  by  the  adviser. ' 

Drafts  under  commercial  letters  01  credit  are  usually  drawn 
payable  "at  sight"  or  at  30,  60,  or  90  days  or  some  other  period 
"after  sight."  "After  sight"  means  after  the  day  the  drafts 
have  been  presented  to  the  drawee  for  acceptance.  Sight  drafts, 
known  also  as  "demand"  drafts,  must  theoretically  be  pre- 
sented by  the  corresponding  banker  at  the  drawee's  address 
immediately  upon  receipt  and  must  then  and  there  be  paid. 

Credits  in  foreign  trade  are  in  the  great  majority  of  instances 
based  upon  the  acceptances  of  time  drafts.  When  the  draft  has 
been  accepted  it  becomes  the  equivalent  of  a  promissory  note, 
but  has  the  additional  characteristic  of  containing  on  its  face 

'  Federal  Reserve  Bulletin,  February  192 1. 


390  BANKING  AND  CREDIT  [XXVIII 

evidence  of  an  undisputed  commercial  transaction.  With  the 
dehvery  of  the  bills  of  lading,  upon  the  acceptance  of  a  time  draft, 
the  extension  of  actual  credit  begins. 

6.  Drafts  Drawn  Directly  on  the  Importer. — The  disadvan- 
tages of  drafts  drawn  directly  on  the  importer  are  summarized 
in  the  advantages  possessed  by  drafts  drawn  under  letters  of 
credit.  Obviously,  if  the  exporter  is  willing  to  have  his  bank 
receive  his  bills  for  collection  instead  of  discounting  them  at  once 
and  advancing  him  the  proceeds,  it  will  ordinarily  be  of  less  im- 
portance whether  the  bills  are  drawn  on  a  bank  or  a  merchant. 
In  case  the  foreign  merchant  has  an  international  reputation,  his 
acceptances  will  find  a  ready  market  and  the  exporter  who  has 
drawn  on  him  should  experience  no  difficulty  in  getting  the  drafts 
discounted. 

Sometimes  in  foreign  trade  when  the  exporter  is  following  the 
plan  of  drawing  drafts  directly  on  the  importer,  a  credit  document 
known  as  an  "authority  to  purchase"  is  issued  by  a  bank  at  the 
importer's  request  and  expense  for  the  benefit  of  the  exporter. 
The  purpose  of  this  document  is  to  give  the  exporter  assurance 
that  he  will  be  able  to  sell  his  drafts  to  his  local  bank  for  cash 
at  the  time  of  shipment  of  the  goods.  The  bank  in  the  exporter's 
country  acting  as  agent  for  the  importer's  bank  will  buy  the 
exporter's  drafts  and  will  then  forward  them  to  the  bank  which 
issued  the  authority  to  purchase,  at  the  same  time  charging  the 
latter's  account. 

7.  The  Drawing  of  Drafts. — In  the  drawing  ot  international 
bills  of  exchange  either  the  debtor  or  the  creditor  may  take  the 
initiative  in  effecting  settlement.  The  debtor  may  purchase  a 
bank  draft  and  send  it  to  the  creditor,  or  the  creditor  may  draw  a 
draft  upon  the  debtor,  the  debtor's  bank,  or  the  latter's  corre- 
spondent. 

Where  the  debtor  takes  the  initiative  he  buys  from  his  local 


XXVIII  ]         THE  PROCESS  OF  FOREIGN  EXCHANGE  391 

bank  a  draft  on  its  foreign  correspondent  in  the  country  to  which 
the  remittance  is  to  be  made.  The  debtor  then  sends  this  draft 
to  the  creditor,  who  cashes  it  or  has  it  discounted  at  his  own  bank. 
The  creditor's  bank  is  wilHng  to  cash  or  discount  the  draft  be- 
cause it  is  the  obHgation  of  a  bank  payable  at  a  central  point 
where  the  creditor's  bank  also  keeps  an  account.  This  method 
of  settlement  is  not  customary  in  regular  commercial  transactions 
and  is  restricted  mostly  to  small  purchases  abroad  by  private 
individuals  who  are  buying  books  or  periodicals,  etc. 

If  the  creditor  takes  the  initiative,  he  draws  a  draft  either  on 
the  debtor,  the  debtor's  bank,  or  the  latter's  correspondent. 
Collection  of  such  a  draft  may  be  made  by  the  creditor  through 
the  agency  of  his  local  bank,  which  will  send  it  to  a  foreign  cor- 
respondent for  payment.  When  the  creditor  takes  the  initiative, 
drafts  arc  drawn  for  the  most  part  on  banks  instead  of  directly 
on  the  debtor.  Such  drafts  are  drawn  under  what  are  known 
as  "  commercial  letters  of  credit,"  which  are  issued  by  the  debtor's 
bank  or  the  latter's  correspondent,  authorizing  the  creditor  to 
draw  bills  of  exchange  upon  it  under  certain  stipulated  condi- 
tions. Generally  speaking,  merchants'  drafts  upon  banks  com- 
mand a  better  price  in  the  market  than  drafts  drawn  directly 
upon  foreign  importers,  principally  for  the  reason  that  the 
drawee  bank  is  usually  better  known  than  the  foreign  importer. 

8.  The  Documentary  Instructions. — Foreign  bills  of  exchange, 
just  as  in  the  case  of  domestic  bills,  may  be  either  "clean"  or 
''documentary."  A  clean  bill  has  no  shipping  papers  or  other 
bills  attached  to  it  to  act  as  collateral  security.  Until  accepted 
a  clean  bill  is  single-name  paper.  After  acceptance  it  becomes 
double-name  paper. 

A  documentary  bill  is  always  secured  by  the  papers  which 
carry  title  to  the  merchandise,  the  sale  of  which  the  bill  repre- 
sents. The  bill  of  lading,  the  insurance  certificate,  consular 
invoice,  and  commercial  invoice  may  be  accompanied  by  a  hypoth- 


392  BANKING  AND  CREDIT  [XXVIII 

ecation  certificate,  specifically  acknowledging  the  goods  covered 
by  the  documents  for  the  protection  of  the  banker  who  discounts 
the  bill.  The  hypothecation  certificate  may  be  an  individual 
statement  covering  only  the  one  shipment,  or  it  may  be  a  blanket 
certificate  covering  all  current  transactions  between  the  exporter 
and  the  banker.  The  importer,  who  is  the  drawee  of  a  docu- 
mentary bill,  has  the  right  in  any  event  to  receive  the  attached 
bill  of  lading  and  other  shipping  documents  at  the  time  when  he 
makes  payment.  However,  he  may  be  treated  more  liberally. 
Shipping  documents  may  be  handed  to  him  for  his  mere  accept- 
ance of  the  draft.  The  disposition  of  these  collateral  documents 
is  determined  by  the  so-called  documentary  instructions.  These 
instructions  may  be : 

1.  Documents  for  payment  (D.P.) 

2.  Documents  for  acceptance  (D.A.) 

3.  Documents  for  delivery  (D.D.) 

Of  the  three  types  of  instructions,  "documents  for  payment" 
give  to  the  holder  the  greatest  security  because  he  retains  posses- 
sion of  the  collateral  until  payment  has  been  made  by  the  foreign 
importer.  These  are  the  usual  instructions  when  a  draft  is  drawn 
on  a  merchant.  When  the  drawee  is  a  bank,  the  terms  are  never 
' '  documents  for  payment ' '  but  rather ' '  documents  for  acceptance ' ' 
or  "documents  for  delivery." 

A  draft  with  a  bill  of  lading  attached  with  the  instructions 
"documents  for  acceptance"  is  called  in  brief  a  "documentary 
acceptance  bill,"  whereas  if  the  instructions  are  "documents  for 
payment"  it  is  called  a  "documentary  payment  bill."  When  the 
drawee  is  a  mercantile  house  of  high  standing  the  instructions 
accompanying  the  draft  may  be  "documents  for  acceptance." 
In  the  case  of  American  cotton  exports,  documentary  acceptance 
bills  were  drawn  in  great  numbers  before  the  war  upon  English 
spinners.  Drafts  drawn  with  the  instructions  "documents 
for  delivery"  are  exceptional.     Instructions  of  this  kind  confer 


XXVIII J         THE  PROCESS  OF  FOREIGN  EXCHANGE  393 

authority  upon  the  agent  of  the  exporter  to  surrender  the  bill 
of  lading  and  other  shipping  documents  even  before  the  accept- 
ance takes  place. 

The  documentary  instructions  are  important  matters  for  the 
exporter  and  the  foreign  importer,  and  also  for  negotiating 
bankers.  Although  the  character  of  the  instructions  depends  to 
a  large  extent  upon  the  usages  of  the  trade  and  the  arrangement 
between  the  merchants,  misunderstandings  and  disputes  are 
frequently  connected  with  this  matter.  If  the  drawer  offers  a 
bill  for  sale  to  a  banker  and  the  latter  instructs  that  the  terms 
be  "documents  for  payment,"  it  is  necessary  for  the  drawer  to 
make  arrangements  with  the  foreign  importers  to  permit  him  to 
accompany  the  bill  with  these  instructions. 

Frequently,  especially  in  the  case  of  sterling  exchange,  time 
bills  are  drawn  with  the  instructions  "documents  for  payment." 
In  such  transactions  the  importer  who  pays  the  draft  is  en- 
titled to  a  rebate  or  discount.  In  England  it  is  the  practice  for 
the  importer  to  make  payment  under  what  is  known  as  the 
"retirement  rate  of  discount,"  also  called  "rebate  rate  of  in- 
terest." This  means  that  the  importer  when  taking  up  his  bill 
will  be  allowed  a  discount  of  1/2  per  cent  above  the  advertised 
rate  of  interest  for  short  deposits  allowed  by  the  leading  London 
joint-stock  banks,  which  is  ordinarily  i  per  cent  below  the  Bank 
of  England's  official  minimum  discount  rate.  In  the  United 
States,  where  documentary  payment  bills  have  been  rare,  there 
has  been  developed  no  standard  practice  in  this  matter;  the 
rate  is  left  to  private  adjustment  between  the  importer  and  the 
bank  holding  the  bill. 

References 

Kniffin,  W.  H.     The  Business  Man  and  His  Bank. 

Contains  forms,  pp.  253-273. 
Langston,  L.  H.     Practical  Bank  Operation. 

A  technical  presentation  of  the  subject  from  the  viewpoint  of  the 
banker.  Vol.  I,  pp.  284-311;  Vol.  II,  pp.  445-448. 


394  BANKING  AND  CREDIT  [  XXVIII 

Moulton,  H.  G.     Financial  Organizations  of  Society.    Part  II. 

Financing  imports  and  exports,  pp.  410-425. 
Shugruc,  M.  J.     Problems  in  Foreign  Exchange. 

Contains  solutions,  copies  of  exchange  documents,   and  foreign 
exchange  tables. 
Wcsterfield,  R.  B.     Banking  Principles  and  Practice. 

Deals  principally  with   the  operations  of   the   foreign   exchange 
departments  of  a  bank,  Vol.  V,  pp.  1200-13 17. 
Whitaker,  A.  C.     Foreign  Exchange. 

Documentary  trade  bill  and  letters  of  credit,  pp.  98-189. 
WiUis,  H.  P.,  and  Edwards,  G.  W.     Banking  and  Business. 

Financing  foreign  trade,  pp.  270-284. 


;     CHAPTER   XXIX 
TYPICAL  FOREIGN  EXCHANGE  TRANSACTIONS 

I.  Financing  an  Export  Shipment  by  Means  of  Dollar  Ac- 
ceptances.— A  Brazilian  importer  in  Rio  de  Janeiro  has  placed 
an  order  with- the  Boston  Leather  Company  for  a  shipment  of 
patent  leather  amounting  to  $75,000  and  has  arranged  with  his 
local  bank  to  finance  the  transaction  on  90  days'  credit.  The 
Rio  de  Janeiro  bank  issues  a  commercial  letter  of  credit  on  its 
banking  correspondent  in  Boston,  the  Hubville  National  Bank, 
requesting  the  latter  to  accept  90-day  sight  drafts  drawn  by  the 
Boston  Leather  Company  under  certain  stipulated  conditions, 
but  not  exceeding  in  total  amount  the  sum  of  $75,000. 

When  the  Hubville  National  Bank  has  received  these  instruc- 
tions, which  would  ordinarily  be  in  the  form  of  a  cable,  it  noti- 
fies the  Boston  Leather  Company  of  the  opening  of  the  credit  and 
states  the  terms  and  conditions.  The  Boston  Leather  Company 
now  ships  the  goods  and  obtains  from  the  steamship  company 
ocean  bills  of  lading.  In  accordance  with  the  terms  of  the  letter 
of  credit  the  local  firm  also  arranges  for  marine  insurance  on  the 
cargo  and  secures  from  the  underwriters  necessary  insurance 
coverage. 

Having  taken  care  of  all  the  shipping  details  the  Boston 
Leather  Company  draws  on  the  Hubville  National  Bank  a  90- 
day  sight  draft  for  the  amount  of  the  shipment  and  attaches  to  it 
the  shipping  documents  stipulated  in  the  letter  of  credit,  includ- 
ing the  original  commercial  invoice,  oceanbillsof  lading,  consular 
invoices,  and  insurance  certificates.  If  everything  is  in  order 
the  Hubville  National  Bank  "accepts"  the  draft  upon  presen- 
tation. The  Boston  Leather  Company  may  hold  the  acceptance 
until  maturity  and  receive  the  full  face  of  the  draft,  but  in  order 

395 


396  BANKING  AND  CREDIT  |  XXIX 

to  obtain  funds  immediately  it  chooses  to  request  the  local  bank 
to  discount  the  draft.  If  the  draft  was  drawn  for  exactly 
$75,000  and  the  discount  rate  on  this  class  of  bills  was  6  per  cent, 
the  proceeds  credited  to  the  Boston  Leather  Company  would  be 
$73,875.     The  following  calculation  is  explanatory: 

Amount  of  90-day  draft $75,000 

Deduct  discount,  90  days'  interest  at  6% 1,125 

Proceeds $73,875 

The  documents  are  immediately  forwarded  by  the  Hubville 
National  Bank  to  the  Rio  de  Janeiro  bank,  which  will  be  advised 
that  a  draft  for  the  amount  of  the  invoice  has  been  accepted  for 
its  account  against  the  credit  issued.  Upon  the  arrival  at  Rio 
de  Janeiro  the  documents  will  be  turned  over  to  the  Brazilian  im- 
porter in  accordance  with  the  bank's  customary  arrangements, 
or  as  previously  agreed  between  the  bank  and  its  customer.  The 
Brazilian  importer  will  then  surrender  the  bill  of  lading  to  the 
steamship  company,  obtain  the  merchandise,  and  from  the  pro- 
ceeds of  its  sale  get  funds  to  pay  his  bank. 

At  the  maturity  of  the  draft  in  New  York  the  Rio  de  Janeiro 
bank  will  be  required  to  deposit  sufficient  funds  v/ith  the  Hub- 
ville National  Bank  to  enable  the  latter  to  meet  its  "acceptance  " 
and  obtain  the  customary  or  previously  agreed  upon  acceptance 
commission. 

2.  Sterling  Draft  Sold  for  Future  Delivery  by  an  American 
Exporter. — In  May  a  Milwaukee  manufacturer  accepts  an  order 
from  an  English  concern  for  some  special  lathes  amounting  to 
£10,000  sterling  for  shipment  to  Manchester  on  or  before  the 
following  October  20.  Fearing  that  a  depreciation  in  the  sterling 
exchange  rates  in  October  might  seriously  diminish  or  wipe 
out  his  profits,  the  Milwaukee  manufacturer  arranges  with  his 
local  bankers  for  sale  to  them  for  future  delivery  in  October, 
drafts  on  the  English  concern's  bank  to  the  amount  of  £10,000 


XXIX  ]    TYPICAL  FOREIGN  EXCHANGE  TRANSACTIONS  397 

at  the  rate  of  $4.22  per  pound.  At  the  rate  of  $4.22  per  pound 
the  Milwaukee  manufacturer  expects  to  be  able  to  realize  his  es- 
timated profit  from  the  sale  of  lathes.  With  the  exchange  thus 
definitely  fixed  he  has  protected  himself  from  any  loss  that  might 
result  from  sterling  exchange  falling  in  October  below  $4.22. 
To  be  sure,  he  has  also  eliminated  the  possibihty  of  any  specu- 
lative profit  due  to  a  rise  in  sterling  rates. 

In  October  when  the  lathes  are  ready  for  shipment  the  Ameri- 
can exporter  draws  a  draft  on  the  English  concern's  bank  and 
delivers  it  to  the  Milwaukee  bankers  to  whom  he  sold  the  October 
exchange  at  $4.22  per  pound.  Whether  the  sterling  exchange 
rate  at  that  time  is  $4  or  $4.50  does  not  matter  because  he  will  re- 
ceive for  his  £10,000,  $42,200,  on  which  he  figured  when  he  sold 
the  future  exchange. 

When  the  Milwaukee  bankers  bought  the  exchange  for  future 
deHvery  they  could  have  protected  themselves  if  they  wished  by 
hedging,  either  by  selling  their  own  long  bills  to  fall  due  in  London 
in  October,  or  by  selling  in  the  local  market  sterling  demand 
drafts  for  October  delivery  to  American  importers  expecting  to 
remit  funds  at  that  time.  Under  either  of  these  two  plans  the 
obligation  of  the  Milwaukee  bankers  will  be  the  same.  The 
latter  alternative,  however,  involves  no  immediate  money  trans- 
action because  the  importers  will  not  be  required  to  make  pay- 
ment to  the  bank  until  the  sterling  drafts  are  delivered  to  them 
in  October. 

3.  Cotton  Shipped  on  Consignment  Financed  by  Dollar  Ac- 
ceptances.— Johnson  Brothers,  cotton-buyers  of  Tulsa,  Okla- 
homa, have  made  arrangements  to  ship  400  bales  of  cotton  costing 
$100,000  on  consignment  to  a  broker  in  Paris  for  sale  after  arrival. 
In  order  to  protect  themselves  from  a  possible  loss  on  account  of  a 
drop  in  prices,  Johnson  Brothers  immediately  hedge  by  selling 
through  their  brokers  futures  at  the  New  York  Cotton  Ex- 
change.   The  Prosperity  Trust  Company  of  New  York  is  then 


398  BANKING  AND  CREDIT  [XXIX 

requested  to  finance  the  shipment,  which  is  to  be  sent  by  railroad 
from  Tulsa  to  New  York  and  from  there  by  steamer  to  Paris. 

Having  agreed  to  finance  the  transaction  by  means  of  a  bank 
acceptance,  the  Prosperity  Trust  Company  authorizes  Johnson 
Brothers  to  draw  upon  it  at  60  days'  sight  for  80  per  cent  of  the 
purchase  price  of  the  cotton,  that  is  $80,000,  with  the  understand- 
ing that  the  railroad  bills  of  lading  covering  the  shipment  are  to 
be  attached  to  the  draft. 

After  making  the  shipment  at  Tulsa,  Johnson  Brothers  draw 
on  the  Prosperity  Trust  Company  a  60-day  sight  bill  and,  having 
attached  to  it  the  railroad  bills  of  lading,  place  it  in  the  mail. 
Four  or  five  days  later  the  New  York  bank  accepts  the  draft  and 
following  the  instructions  of  the  drawer  sells  it  in  the  open  market 
and  credits  the  account  of  Johnson  Brothers  for  the  proceeds. 
Supposing  that  the  discount  rate  for  this  class  of  bills  is  6  1/2  per 
cent,  the  proceeds  placed  to  the  credit  of  Johnson  Brothers  would 
be  $79,133-33: 

Amount  of  60-day  sight  draft $80,000.00 

Deduct  discount,  60  days'  interest  at  6  1/2% 866.67 

Proceeds $79,133-33 

The  bank  retains  the  railroad  bills  of  lading  and  for  addi- 
tional security  requires  Johnson  Brothers  to  sign  an  "acceptance 
agreement"  pledging  the  400  bales  of  cotton  as  collateral  and 
promising  to  provide  the  bank  with  sufficient  funds  to  meet  the 
acceptance  at  maturity. 

When  the  cotton  arrives  in  New  York  the  Prosperity  Trust 
Company,  already  having  arranged  for  cargo  space,  makes  ship- 
ment to  Paris  and  obtains  the  necessary  ocean  steamer  bills  of 
lading.  As  previously  arranged  between  the  bank  and  its  cus- 
tomer, insurance  on  the  cotton  while  in  transit  to  Paris  is  to  be 
provided  for  by  Johnson  Brothers  and  the  policies  are  to  be  sent 
to  the  Prosperity  Trust  Company.  These  policies  together  with 
the  ocean  steamer  bills  of  lading  will  be  forwarded  by  the  bank 


XXIX]    TYPICAL  FOREIGN  EXCHANGE  TRANSACTIONS  399 

to  its  French  correspondent.  Instructions  will  be  sent  at  the 
same  time  to  the  effect  that  on  arrival  the  cotton  is  to  be  stored 
in  a  warehouse  pending  further  advice. 

Johnson  Brothers'  French  broker  is  notified  of  the  arrival  of 
cotton  by  the  Paris  bank  and  he  immediately  takes  steps  to  dis- 
pose of  the  consignment  in  his  local  market.  When  the  sale  has 
been  completed  the  Paris  bank,  acting  upon  instructions  from 
its  New  York  correspondent,  will  deliver  the  cotton  to  the  buyer 
against  payment  in  francs  for  the  amount  of  the  sale  or  against 
a  written  promise  to  pay  within  a  specified  number  of  days. 

On  settlement  of  the  transaction  by  the  Paris  cotton-buyer, 
the  Prosperity  Trust  Company  will  be  notified  by  its  French 
correspondent  that  an  amount  specified  has  been  collected  and 
has  been  placed  to  the  credit  of  the  New  York  bank.  The  Pros- 
perity Trust  Company  will  immediately  convert  the  Paris  credit 
into  dollars  at  the  market  rate  for  cable  transfers  on  Paris.  The 
proceeds  of  the  sum  converted  into  dollars  will  be  applied  to  pay- 
ment of  Johnson  Brothers'  draft  of  $80,000  and  the  balance,  after 
deducting  the  necessary  commission  charges,  is  placed  to  their 
credit. 

Not  infrequently  it  happens  that  the  American  bank  receives 
funds  from  abroad  before  the  maturity  of  its  acceptances.  In 
such  cases  the  banking  practice  is  to  allow  the  customer  a  rebate 
of  interest  until  the  maturity  of  the  draft. 

4.  Financing  an  Importation  of  Gutta-Percha  from  Singapore 
with  Sterling  Exchange. — Lincoln  Brothers  of  Boston  have  ar- 
ranged with  the  Hubville  National  Bank  to  have  a  90  days'  credit 
opened  with  the  Middlesex  Bank,  Ltd.,  of  London,  in  favor  of  the 
Oriental  Export  Company  of  Singapore  against  shipments  of 
gutta-percha  to  Boston.  After  receiving  the  Boston  bank's 
letter  of  credit  authorizing  drafts  on  the  Middlesex  Bank,  Ltd., 
under  certain  stipulated  conditions,  the  Oriental  Export  Com- 
pany, already  having  secured  cargo  space,  makes  shipment.    At 


400  BANKING  AND  CREDIT  [XXIX 

the  same  time  it  draws  on  the  London  bank  a  90-day  sight  bill 
for  £50,000  and  attaches  to  it: 

1.  Ocean  steamer  bill  of  lading 

2.  Consular  invoice 

3.  Marine  insurance  policies 

4.  Commercial  invoice 

The  draft  with  documents  attached  will  be  sold  by  the 
Oriental  Export  Company  to  its  local  bank  in  Singapore  at  the 
market  rate  in  the  currency  of  the  Straits  Settlements  (Straits 
dollars)  for  90-day  sight  bills  on  London.  Unless  for  some 
reason  the  terms  of  the  credit  have  not  been  fulfilled  and  the 
draft  is  not  accepted  in  London,  the  transaction  is  concluded  so 
far  as  the  Singapore  exporters  are  concerned.  The  Singapore 
bank  will  now  send  the  original  shipping  documents  direct  to  the 
Boston  bank  so  that  no  delay  will  be  incurred  by  the  American 
importers  in  obtaining  the  goods  after  arrival,  and  will  forward 
the  draft  with  duplicate  shipping  documents  to  its  correspondent 
in  London,  who  will  present  the  bill  to  the  Middlesex  Bank,  Ltd., 
for  acceptance.  If  this  bank  is  satisfied  that  all  the  terms  of 
the  letter  of  credit  have  been  properly  observed,  it  will 
accept  the  draft,  retain  the  documents,  but  return  the  draft  itself 
to  the  Singapore  bank's  correspondent.  The  latter  will  either 
hold  the  draft  until  maturity  93  days  hence  (90  days  plus  3  days 
of  grace)  or  sell  it  in  the  discount  market,  depending  upon  the 
instructions  from  Singapore.  With  the  London  discount  rate 
on  90-day  sight  bills  at  6  per  cent  and  stamp  charges  at  1/20  per 
cent,  the  proceeds  placed  to  the  credit  of  the  Singapore  bank  in 
London  in  case  instructions  call  for  the  immediate  sale  of  the  bill, 
would  be  £49,210  I2S.  4d.     This  is  arrived  at  as  follows: 

1.  Amount  of  90-day  sight  draft £50,000 

2.  Deduct  93  days'  discount  at  6% 764.  7.8 

3.  Deduct  stamp  charges  of  i  /20% 25.  0.0 

4.  Proceeds £49,210.12.4 


XXIX  ]      TYPICAL  FOREIGN  EXCHANGE  TRANSACTIONS       4OI 

The  duplicate  shipping  document  will  be  forwarded  immedi- 
ately by  the  Middlesex  Bank,  Ltd.,  to  the  Boston  bank  in  order 
to  prevent  any  inconvenience  that  might  be  occasioned  by  the 
loss  or  delay  in  transit  of  the  original  documents.  The  Boston 
bank  will  also  be  notified  at  the  same  time  by  its  London  corre- 
spondent concerning  the  acceptance  of  the  draft  and  will  be 
expected  to  provide  in  London  at  its  maturity  £50,000  for  cover. 

On  the  arrival  of  the  gutta-percha  in  this  country  Lincoln 
Brothers  will  wish  to  obtain  possession  of  it  for  manufacturing 
purposes,  but  since  their  bank  holds  the  documents  the  cargo  can- 
not be  secured  from  the  steamship  company  until  the  bill  of  lading 
has  been  surrendered.  The  Boston  bank  will  want  to  retain  some 
control  over  the  goods  and  therefore  let  us  assume  the  request  of 
their  customer  to  sign  a  trust  receipt  in  return  for  the  bill  of 
lading. 

Although  the  form  and  terms  of  a  trust  receipt  vary,  in  general 
this  document  specifies  that  the  title  to  the  goods  remains  with 
the  bank  and  that  they  are  being  held  in  trust  by  the  customer. 
Furthermore,  the  customer  agrees  to  turn  over  to  the  bank  cer- 
tain proceeds  of  the  sale  of  the  manufactured  goods  until  the 
debt  is  settled.  Moreover,  the  bank  reserves  the  right  to  take 
possession  of  the  goods  at  any  time,  although,  should  this  action 
be  considered  necessary  on  account  of  such  a  matter  as  financial 
embarrassment  of  the  customer,  no  little  difficulty  might  be 
experienced  in  determining  which  of  the  goods  were  actually 
covered  by  the  trust  receipt. 

It  is  not  customary,  however,  for  a  bank  in  this  case  to  insist 
rigidly  upon  the  terms  of  its  contract  unless  there  is  danger  that 
the  customer  will  not  be  able  to  meet  his  obligations.  There- 
fore, as  a  matter  of  practice,  the  Boston  bank,  while  reserving  the 
right  to  enforce  the  provisions  of  the  trust  receipt,  will  not  expect 
Lincoln  Brothers  to  make  payment  until  it  is  necessary  to  remit 
to  London  to  cover  the  draft,  which  will  become  due  there  93 
days  from  the  date  of  its  acceptance  by  the  Middlesex  Bank, 
26 


402  BANKING  AND  CREDIT  [XXIX 

Ltd.  The  Boston  bank  will  give  its  customer  the  choice  of  set- 
tling by  means  of  a  bankers'  check  on  London,  which  would  have 
to  be  purchased  for  mailing,  let  us  say,  lo  days  before  the  ma- 
turity of  the  bill  in  London,  or  of  remitting  by  cable  some  9  days 
later.  Assuming  that  Lincoln  Brothers  choose  the  former  plan 
and  bankers'  checks  on  London  are  selling  at  3.46  3/4,  they  will 
send  to  the  Boston  bank  their  personal  check  for  $173,375 
(£50,000  times  3.46  3/4)  plus  a  commission  of,  say,  3/4  per  cent, 
amounting  to  $1,300.31,  or  a  total  of  $174,675.31. 

5.  Remitting  Funds  to  Calcutta  for  Purchasing  Jute. — The 

Lancaster  Bag  Company  of  Brooklyn  is  planning  to  instruct 
its  purchasing  agent  in  Calcutta  to  buy  for  immediate  ship- 
ment jute  costing  approximately  200,000  rupees.  Before  the 
war  the  Brooklyn  firm  provided  its  Calcutta  agent  with  funds 
through  purchasing  rupees  in  London  for  remittance  to  India. 
To  be  more  explicit,  the  Lancaster  Bag  Company  followed  the 
policy  of  buying  sterling  cables  in  the  New  York  market  to  be 
used  for  remittance  to  a  London  correspondent  who  was  in- 
structed to  buy  rupee  cables  for  remittance  to  Calcutta.  At 
this  particular  time  its  procedure  is  to  make  direct  remittance 
in  rupees  from  New  York  to  Calcutta.  This  plan  makes  it  pos- 
sible for  the  American  importer  to  avoid  the  exchange  risks  due 
to  fluctuations  in  the  rates  for  the  pound  sterling.  In  other 
words,  indirect  remittance  through  London  brought  into  the 
transaction  an  additional  factor  of  instability,  namely,  the 
changing  sterling-rupee  rate,  and  made  it  impossible  to  deter- 
mine at  the  time  the  amount  of  funds  necessary  to  be  for- 
warded to  London  in  order  to  purchase  the  required  amount  of 
rupees. 

When  the  Lancaster  Bag  Company  has  decided  to  make  re- 
mittance to  its  agent  in  India,  it  will  arrange  through  its  New 
York  bank  to  have  the  necessary  number  of  rupees  forwarded 
to  Calcutta.     Upon  settlement  of  the  transaction  with  the  local 


XXIX  ]      TYPICAL  FOREIGN  EXCHANGE  TRANSACTIONS       403 

bank,  the  Lancaster  Bag  Company  will  be  given  a  receipt  with  a 
statement  that  200,000  rupees  are  to  be  telegraphed  immediately 
to  the  Calcutta  agent  of  the  Brooklyn  firm. 

If  at  this  particular  time  the  telegraphic  transfer  rate  be- 
tween London  and  Calcutta  is  2s.  ^d.  and  between  New  York  and 
London  $3.60,  the  Brooklyn  concern  should  have  bought  the 
rupees  at  $.42.     The  following  computation  is  self-explanatory: 

1.  £1  =  20s.  =  24od. 

28 

2.  Cost  of  I  rupee  in  London  2s.  Ad.  =  2%d.,  or  £ 

240 

3.  Cost  of  £1  or  240^.  in  New  York  =  $3.60 

28 

4.  Therefore, X  $3-6o  =  $.42,  cost  of  i  rupee  in  New  York 

240 

Proof: 

1.  Cost  of  Rs.  200,000  at  $.42  =$84,000 

2.  If  indirect  remittance  were  made  through  London,  $84,000  at  $3.60 

per  pound  would  provide  £23,333  1/3  in  London. 

28 

3.  £23,333  1/3  at per  rupee  would  provide  Rs.  200,000  m  Calcutta. 

240 

6.  Finance  Bills. — Finance  bills  are  foreign  drafts  drawn  for 
the  purpose  of  making  available  the  funds  obtained  in  connection 
with  a  financial  transaction,  such  as  an  issue  of  stocks  or  bonds; 
or  a  reorganization,  a  readjustment,  or  an  underwriting.  The 
term  is  also  commonly  applied  to  a  long  bill  drawn  by  a  banker 
in  one  country  on  a  banker  in  another,  generally  against  bal- 
ances or  securities  pledged  for  the  latter's  account.'  The  pur- 
pose of  a  finance  bill  of  this  latter  class  may  be:  (i)  to  anticipate 
a  fall  in  foreign  exchange  rates,  (2)  to  take  advantage  of  higher 
interest  rates  in  one  country  than  in  another,  and  (3)  to  raise  funds 
regardless  of  the  conditions  of  interest  or  exchanges. 

For  instance,  under  normal  conditions  large  exports  of  grain 


'  Not  all  long  bills  drawn  by  bankers  are  finance  bills.  Often  bankers  draw  long  bills 
in  connection  with  the  purchases  of  commercial  and  other  forms  of  exchange  more  or  less  as  a 
part  of  the  regular  daily  routine. 


404  BANKING  AND  CREDIT  [XXIX 

and  cotton  in  the  autumn  cause  the  rates  on  sterhng  exchange  to 
drop  from  previous  higher  levels  in  the  summer  months.  About 
the  middle  of  August  a  New  York  banker  wishing  to  take  ad- 
vantage of  an  expected  drop  in  exchange  rates  arranges  with  his 
London  correspondent  for  a  60  days'  credit  of  £50,000  by  pledg- 
ing securities  for  the  latter's  account  at  an  acceptable  New  York 
trust  company,  although  not  infrequently  in  such  cases  a  credit 
is  extended  without  any  collateral  requirements. 

The  New  York  banker  immediately  proceeds  to  draw  a  60- 
day  sight  bill  on  London.  He  may  realize  on  this  bill  at  once 
by  selling  it  in  New  York  at  the  market  rate  for  60-day  bills,  or 
he  may  send  it  to  London^  to  be  discounted  and  sell  his  own  de- 
mand drafts  against  the  proceeds  of  the  credit  thus  obtained.  If 
he  follows  the  second  plan,  the  New  York  banker  will  not  be  re- 
quired to  wait  until  he  has  been  informed  that  the  bill  has  been 
accepted  and  discounted  in  London  before  selling  the  demand 
drafts.  It  is  quite  possible  for  the  same  steamer  to  carry  the 
60-day  bill  and  the  demand  drafts.  Of  course,  the  proceeds 
cannot  be  foretold  to  the  exact  amount,  but  this  is  not  vital,  as 
the  demand  drafts  would  probably  not  be  drawn  for  the  exact 
amount  of  the  proceeds.  Any  balance  would  be  debited  or 
credited  to  the  New  York  bank's  account  in  London. 

Let  us  assume  that  the  New  York  banker  chooses  the  second 
plan  and  that  the  pertinent  facts  are: 

1.  August  15  the  rate  for  bankers'  checks  on  London $4.88 

2.  London  arrival  discount  rate  on  60-day  sight  bills 4% 

3.  EngHsh  stamp  charges  on  60-day  sight  bills 1/20% 

4.  London  banker's  commission 1/8  % 

5.  New  York  tanker  employs  funds  for  63  days  at  an  average 

rate  of 6% 

6.  Ten  day    before  maturity  of  the  London  draft  the  New- 

York  banker  remits  with  a  demand  draft  purchased  at  $4.84 


^  The  London  bank  will  quote  a  discount  rate  "to  arrive,"  that  is  in  advance,  and 
the  New  York  banker  will  thus  know  the  exact  amount  of  the  demand  exchange  he  can 
market. 


XXIX]      TYPICAL  FOREIGN  EXCHANGE  TRANSACTIONS       405 

Computation  : 

1.  Amount  of  60-day  sight  bill £50,000 

2.  Deduct  London  discount,  63  days'  interest  at  4% 345.  4.   i 

3.  Deduct  English  stamp  charges  1/20% 25.  o.  o 

4.  Proceeds  in  London £49,629.15.1 1 

5.  Sells  demand  draft  in  New  York  at $4.88 

6.  Proceedsof  demand  draft  £49,629.15.11  at  $4.88 $242,193.40 

7.  New  York  banker  employs  these  funds  for  63  days  at  an 

averageinterest  rate  of  6%  earning 2,543.03 

8.  Total  proceeds  and  interest $244,736.43 

9.  At  end  of  60  days  New  York  banker  buys  a  sterling  de- 

mand draft  for  £50,062.10.0  (50,000  plus  1/8%  com- 
mission) for  remittance  to  London  at  $4.84  costing 242,302.50 

10.  New  York  banker's  profit  (8  minus  9) $2,433.93 

It  is  evident  that  if  the  New  York  banker  had  been  able  to 
obtain  the  necessary  cover  for  the  original  draft  on  his  London 
correspondent  at  less  than  $4.84,  he  would  have  made  an  addi- 
tional profit,  and  that  if  the  rate  were  much  above  $4.84,  he  would 
have  incurred  a  loss.  This  brings  into  the  transaction  an  ele- 
ment of  risk  which  the  New  York  banker  may  or  may  not  wish 
to  take.  In  case  he  wishes  to  avoid  the  risk  he  may  hedge 
through  buying  exchange  for  future  delivery  instead  of  waiting 
until  the  time  of  remittance  to  make  the  purchase. 

In  the  illustration  just  given,  whether  the  New  York  banker 
would  choose  to  sell  the  60-day  sight  bill  outright  in  the  New 
York  market  or  follow  the  plan  described  would  depend  upon  the 
quotations  for  demand  and  60-day  bills.  If  the  rate  for  60-day 
bills  were  more  than  $4.843868  it  would  be  more  profitable  to 
dispose  of  his  London  credit  by  way  of  a  60-day  bill.  The  fol- 
lowing computation  is  self-explanatory: 

1.  Amount  of  60-day  bill £50,000 

2.  Proceeds  in  New  York  from  sale  of  bill  at  $4.843868 $242,193.40 

3.  Proceeds  of  demand  draft  in  New  York  at  $4.88,  (line  6  in 

computation  above) $242,193.40 


406  BANKING  AND  CREDIT  |  XXIX 

It  will  be  observed  that  neither  the  New  York  banker  nor  his 
London  correspondent  were  required  to  advance  any  money. 
The  London  correspondent  cHd  not  loan  any  money  but  merely 
accepted  the  draft  and  was  provided  with  the  necessary  funds 
to  meet  it  at  maturity.  The  actual  funds  were  supplied  by  the 
London  discount  market  which  in  discounting  the  bill  was  pro- 
tected by  the  primary  liability  of  the  drawee  bank  and  the 
secondary  liability  of  the  drawer.  This  very  ready  means  of 
raising  funds  might  seem  to  be  open  to  serious  objection  because 
of  the  possibility  of  abuse,  but  as  a  matter  of  fact  any  such  danger 
is  carefully  guarded  against.  It  is  the  policy  of  the  London  dis- 
count market  to  keep  informed  as  to  the  financial  condition  of 
both  the  drawer  and  acceptor.  Higher  discount  rates  and,  if 
necessary,  refusal  to  take  the  paper  prove  the  most  effective 
checks  that  can  be  devised  by  the  discount  market  against  any 
attempt  to  issue  finance  bills  beyond  reasonable  limits. 

Finance  bills  perform  two  important  economic  functions.  In 
transferring  loanable  funds  from  one  market  to  another  they 
tend  to  equalize  interest  rates  in  the  different  financial  centers. 
In  anticipating  a  drop  in  foreign  exchange  prices  they  tend  to  in- 
crease the  supply  of  bills  when  prices  are  high  and  increase  the 
demand  for  bills  when  prices  are  low  and  thus  cause  exchange 
rates  to  be  more  nearly  uniform  throughout  the  year. 

Since  the  war  the  lack  of  stability  in  the  foreign  exchange 
markets,  together  with  higher  interest  rates  abroad,  have  caused 
a  marked  decrease  in  the  drawing  of  finance  bills. 

7.  Arbitrage  Transactions. — Arbitrage  in  foreign  exchange 
may  be  described  in  simple  language  as  the  buying  of  drafts  in 
one  market  at  a  low  price  and  selling  them  in  another  market  at  a 
high  price.  Essentially,  the  operation  is  very  similar  to  what 
happens  when  traders  buy  grain,  cotton,  or  other  commodities  in 
one  city  for  resale  at  a  profit  in  another  city. 

For  instance,  since  sterling  drafts  are  sold  in  all  the  money 


XXIX  ]      TYPICAL  FOREIGN  EXCHANGE  TRANSACTIONS       407 

markets  of  the  world  it  might  be  expected  that  there  would  be 
one  rate  between  dollars  and  pounds  in  New  York  and  another 
in  San  Francisco;  or  that  the  rate  between  dollars  and  pounds 
would  differ  as  to  whether  the  exchange  were  made  directly  on 
London  or  indirectly  through  the  medium  of  French  francs, 
Swiss  francs,  Italian  lire,  or  Japanese  yen.  It  is  the  purpose  of 
the  following  illustration  to  explain  how  the  forces  of  competi- 
tion tend  to  estabhsh  a  parity  in  price  quotations  in  the  exchange 
markets  throughout  the  world. 

Let  us  assume  that  at  a  certain  time  the  cable  rates  between 
New  York,  London,  and  Paris  are  as  follows: 

1.  New  York  rate  on  London $3-25 

2.  "         "       "       "  Paris 6.50  cents 

3.  London         "       "      "     51  francs 

A  foreign  exchange  trader  in  New  York  remits  £10,000  by  cable 
to  his  London  correspondent  with  instructions  that  these  funds 
be  used  for  purchasing  francs  to  be  forwarded  to  a  Paris  corre- 
spondent. At  $3.25  per  pound,  £10,000  would  cost  $32,500  and 
with  this  sum  of  English  money  the  London  correspondent  would 
buy  cables  on  Paris  at  the  rate  of  51  francs  to  the  pound. 
£10,000  would,  therefore,  establish  in  Paris  a  credit  of  510,000 
francs  in  favor  of  the  New  York  foreign  exchange  trader.  The 
latter  would  then  be  in  a  position  to  sell  New  York  exchange  on 
Paris  at  the  rate  of  6.50  cents  per  franc  and  by  selling  510,000 
francs  he  would  receive  $33,150.  But  since  he  started  with  only 
$32,500  this  rapid  trading  from  New  York  to  London,  to  Paris  and 
back  to  New  York  again  has  yielded  a  profit  of  $650  less  broker- 
age commissions  and  incidental  expenses. 

In  the  illustration  just  given  francs  are  cheaper  in  London 
than  in  New  York.  With  the  foreign  exchange  traders  all  over 
the  world  continually  on  the  alert  for  such  opportunities  for 
profit  there  would  be  stimulated  immediate  buying  of  francs  in 
London  for  sale  in  New  York.    These  trading  operations  would 


408  BANKING  AND  CREDIT  [  XXIX 

tend  to  establish  very  quickly  a  parity  in  the  foreign  exchange 
quotations  in  New  York,  London,  and  Paris,  that  is,  in  this  parti- 
cular instance  bring  about  rates  that  would  offer  no  opportunity 
to  make  a  profit  through  the  triangular  transaction  of  buying 
francs  in  London,  remitting  them  to  Paris  for  credit,  and  selling 
drafts  in  New  York  against  this  credit.  It  is  not  difficult  to 
understand  why  this  condition  could  be  created  as  a  result  of 
a  change  in  any  one,  two,  or  each  of  the  three  rates.  For  in- 
stance, if  we  assume  the  New  York  rate  on  London  to  continue 
at  $3.25  and  the  New  York  rate  on  Paris  to  remain  at  6.50  cents, 
the  London  parity  rate  on  Paris  would  be  50  francs  per  pound 
(3.25  -h  .065).  Similarly,  if  we  assume  the  London  rate  on  Paris 
and  the  New  York  rate  on  Paris  to  remain  unchanged,  the  New 
York  parity  rate  on  London  would  be  $3,315  (51  X  -065). 
Finally,  if  we  assume  the  London  rate  on  Paris  and  the  New  York 
rate  on  London  to  remain  unchanged,  the  New  York  parity  rate 
on  Paris  would  be  $.06176  (3.25  -^  51).  As  a  practical  matter 
it  is  more  reasonable  to  expect  that  a  parity  would  be  established 
as  a  result  of  interactions  and  changes  in  each  of  the  markets 
rather  than  of  a  rise  or  fall  of  rates  in  only  one  market.  The 
final  effect  would  be  the  same  in  any  event. 

References 

Exporters'  Encyclopedia.     Published  yearly  with  monthly  supplements. 

Technical  information  for  the  exporter  and  importer. 
Margraff,  A.  W.     International  Exchange. 

Technical  banking  features  of  foreign  exchange.     Also  contains 
much  illustrative  problem  material. 
Shugrue,  M.  J.     Problems  in  Foreign  Exchange. 

Contains  illustrative  problems  with  and  without  solutions. 
York,  T.     Foreign  Exchange. 

Practical  problems  in  foreign  exchange,  pp.  167-169. 


CHAPTER  XXX 
THE  NEW  YORK  MONEY  MARKET 

I.  Flow  of  Money. — Just  as  grain  flows  from  the  farms  and 
the  country  elevators  into  the  primary  markets,  such  as  Chicago, 
Duluth,  and  Kansas  City,  for  subsequent  distribution,  so  large 
quantities  of  money  and  credit  instruments  find  their  way  to  New 
York,  the  great  money  market  of  the  United  States.  A  money 
market  is  in  reality  principally  a  credit  market.  When  interest 
rates  are  high  it  is  commonly  stated  that  "money  is  scarce," 
but  strictly  speaking  credit  has  become  difficult;  the  volume  of 
money  has  probably  remained  substantially  unchanged.  Al- 
though the  price  of  grain  will  usually  vary  slightly  in  different 
markets  of  the  country,  the  spread  cannot  for  any  length  of  time 
be  greater  than  an  amount  representing  the  transportation,  in- 
surance and  interest  charges,  and  a  small  margin  of  profit,  because 
when  it  exceeds  this  amount  traders  will  be  induced  to  buy  in  the 
cheaper  and  sell  in  the  dearer  place,  thus  correcting  the  situation. 
Interest,  or  the  price  for  the  use  of  money  or  credit,  is  subject  to 
much  the  same  influences  and  its  rates  tend  to  move  in  the  same 
direction  whether  it  be  New  York,  Chicago,  or  Seattle.  However, 
because  money  is  loaned  in  the  various  markets  under  different 
conditions  of  risk  and  because  its  flow  from  one  place  to  another 
must  first  overcome  varying  degrees  of  inertia,  it  is  not  surprising 
that  the  level  of  interest  rates  should  be  slightly  higher  at  one 
point  than  at  another. 

Wall  Street,  the  financial  center  of  New  York,  is  intimately 
connected  with  the  monetary  reservoirs  of  other  parts  of  the 
country,  and  in  fact  with  those  of  the  whole  world.  High  interest 
rates  open  the  conduits  through  which  flow  supplies  of  yellow 
metal  from  the  Klondike  and  the  Transvaal,  domestic  funds  from 

409 


4IO  BANKING  AND  CREDIT  I XXX 

interior  points,  and  foreign  money  from  London,  Paris,  and  Ber- 
lin. Similarly,  lower  interest  rates  tend  to  check  and  in  many 
cases  to  reverse  the  flow  of  funds,  thus  bringing  about  a  more 
even  distribution  of  money  in  the  world's  financial  centers.  In 
studying  the  conditions  affecting  the  money  rates  in  the  United 
States  it  is  important,  therefore,  to  examine  the  forces  that  are 
operative  in  the  New  York  money  market. 

The  rate  of  interest  which  must  be  paid  for  borrowed  money 
depends  upon  the  supply  and  the  demand  for  funds.  As  in  the 
case  of  practically  all  commodities  bought  and  sold  in  a  market, 
anticipated  future  demand  and  supply  as  well  as  present  demand 
and  supply  are  factors.  This  is  true  of  commodities,  as  is  seen  in 
the  variation  of  price  for  immediate  dehvery  and  price  for  future 
delivery.  The  price  of  cotton  may  be  high  for  spot  delivery  and 
low  for  delivery  in  3  months,  if  there  be  an  expectation  that  future 
demand  will  diminish  or  that  a  large  new  crop  is  forthcoming. 
So  it  is  with  the  price  or  interest  of  money.  The  money  market  is 
organized  to  meet  these  conditions  and  needs.  There  is  conse- 
quently a  demand  or  call  money  market  and  a  time  money  mar- 
ket. As  a  rule  there  is  a  close  relationship  between  the  two,  but 
at  times  there  may  be  a  marked  difference. 

2.  New  York  Bank  Statement. — In  the  New  York  money 
market  certain  evidence  in  regard  to  the  supply  of  loanable 
money  is  furnished  each  week  in  the  published  statement  of 
bank  and  trust  company  conditions  summarized  by  the  New 
York  Clearing  House.  From  these  it  is  possible  to  determine: 
(i)  the  amount  of  loans,  discounts,  and  investments;  (2)  cash  in 
vault;  (3)  reserve  with  legal  depositories;  (4)  deposits,  both  de- 
mand and  time;  and  (5)  the  surplus  reserve,  that  is,  the  reserve  in 
excess  of  legal  requirements.  This  statement  is  published  on 
Saturday.  As  not  all  of  the  banks  are  members  of  the  federal 
reserve  system,  and  as  state  banks  which  are  not  members  are  not 
subject  to  the  same  reserve  requirements,  the  weekly  statement  is 


XXX  ]        THE  NEW  YORK  MONEY  MARKET         4I I 

in  a  composite  form  showing:  (i)  condition  of  member  banks  and 
trust  companies,  and  (2)  condition  of  non-member  institutions. 
Knowing  the  reserve  requirements  for  each  of  the  two  classes, 
it  is  possible  to  calculate  the  reserve  position  and  surplus  funds 
of  the  two  classes  combined. 

A  further  distinction  is  made  between  "actual"  figures  and 
"average"  figures  in  the  New  York  Clearing  House  statement. 
Actual  figures  are  those  for  the  close  of  business  on  Friday; 
average  figures  are  obtained  by  taking  the  average  of  the  figures 
for  each  day  of  the  week.  In  normal  weekly  periods  the  average 
figures  are  the  better  index  of  banking  conditions,  as  they  take 
into  account  all  of  the  operations  of  the  week.  If,  however, 
there  is  a  continuous  movement  in  process,  as  in  the  piling-up  of 
funds,  or  steady  withdrawal  of  money,  the  actual  figures,  given 
for  the  last  day  of  the  period,  are  an  aid  in  disclosing  the  extent  of 
the  movement. 

3.  New  York  Money  Rates. — The  above  explanation  may  be 
illustrated  by  the  table  on  page4i  2  showing,  for  aseries  of  weeks  in 
192 1,  the  condition  of  New  York  banks'  current  rates  on  call 
money  and  commercial  paper,  and  the  discount  rate  of  the  New 
York  Federal  Reserve  Bank. 

4.  Reserve  in  the  Bank  Statement. — Before  the  establishment 
of  the  federal  reserve  system,  and  more  particularly  before  the 
transfer  of  all  reserves  of  member  banks  to  a  federal  reserve  bank, 
the  amount  of  the  surplus  reserve  of  banks  was  generally  re- 
garded as  an  index  of  the  bank's  ability  to  make  additional  loans 
and  of  the  probable  trend  of  rates  of  interest  on  money.  This 
relationship,  however,  is  no  longer  so  evident.  Under  the  new 
law  a  member  bank  establishes  its  reserve,  not  only  by  transfer- 
ring cash  to  the  federal  reserve  banks  but  by  borrowing  from  the 
federal  reserve  bank,  either  by  loans  on  acceptable  collateral  or  by 
rediscounts  of  commercial  paper.     The  potential  reserve  is  no 


412 


BANKING  AND  CREDIT 


XXX 


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XXX]  THE  NEW  YORK  MONEY  MARKET  413 

longer  measured  by  the  cash  of  member  banks,  but  by  the  char- 
acter of  the  assets  available  for  receiving  credits  at  the  federal 
reserve  bank,  and  also  by  the  abihty  of  the  federal  reserve  bank 
to  grant  such  credits.  From  the  published  statements  of  the 
clearing  house  banks,  it  is  impossible  to  determine  the  amount  of 
assets  which  the  member  banks  can  pledge  with  the  federal  re- 
serve bank  and  thus  convert  into  a  reserve.  The  amount  of 
"cash  in  vault,"  which  might  be  transferred  by  a  member  bank 
to  the  federal  reserve  bank,  though  precisely  stated,  is  small  and 
may  be  disregarded  as  a  potential  influence  in  providing  loaning 
facilities.  The  member  bank  may,  however,  by  rediscounting 
at  the  federal  reserve  bank  suddenly  increase  its  reserve  by  mil- 
lions of  dollars,  and  for  this  reason  the  fluctuations  in  the  surplus 
reserve  may  be  due  simply  to  bookkeeping  operations  between 
the  member  bank  and  the  federal  reserve  bank.  As  a  result  the 
weekly  statement  of  the  New  York  Clearing  House  members, 
taken  by  itself,  without  comparison  with  other  statements,  has 
lost  much  of  its  significance. 

Not  only  must  the  member  banks  have  acceptable  assets  to 
pledge  with  the  federal  reserve  bank  in  order  to  increase  its 
reserve,  but  the  federal  reserve  bank  must  be  in  a  position  to  grant 
the  credit.  This  in  turn  depends  upon  the  condition  of  the 
federal  reserve  bank.  It,  too,  must  maintain  a  reserve.  The 
weekly  statement  of  the  New  York  Federal  Reserve  Bank  must 
therefore  be  examined  as  well  as  that  of  the  New  York  Clearing 
House  members.  According  to  law  each  of  the  twelve  reserve 
banks  is  required  to  keep  on  hand  a  lawful  money  reserve  of 
35  per  cent  against  deposits  of  member  banks  and  40  per  cent 
against  its  own  notes.  Obviously,  when  the  actual  reserve  closely 
approximates  the  lawful  reserve  the  abihty  of  the  reserve  banks 
to  accommodate  their  members  has  approached  its  limit  and  the 
situation  is  apt  to  be  acute.  If,  however,  the  reserve  ratio  is  high 
or  is  on  the  increase  any  flurry  in  the  rates  of  interest  should  cause 
no  great  alarm. 


414  BANKING  AND  CREDIT  (XXX 

5.  Factors  Affecting  the  Money  Market. — The  condition  of 
New  York  banks,  as  reflected  in  the  weekly  statements,  is  deter- 
mined and  modified  by  a  great  variety  of  economic  movements. 
The  following  may  be  mentioned  as  especially  significant: 

1.  The  volume  of  manufacturing,  commercial,  and  mercan- 

tile business. 

2.  The  volume  of  speculation  and  transactions  in  the  New 

York  Stock  Exchange. 

3.  Flow  of  funds  to  and  from  the  interior. 

4.  Financial  transactions  with  the  government,  as  payment 

of   maturing  indebtedness,   purchase   of  government 
securities,  and  payment  of  federal  taxes. 

5.  Import  or  export  of  gold. 

6.  Issue  of  new  securities. 

7.  Dividend   and   interest  disbursements  at  the  quarterly 

periods. 
The  interplay  of  these  movements  afTects  the  money  market 
in  any  locality,  but  is  much  more  marked  in  New  York  City, 
because  financial  operations  are  on  so  large  a  scale  there.  Experts 
endeavor  to  analyze  the  changes  as  reflected  in  the  bank  state- 
ments and,  in  the  light  of  known  current  commercial  and  finan- 
cial transactions,  to  interpret  and  predict  the  probable  course  of 
the  money  market. 

6.  Course  of  Money  Rates. — As  a  rule  money  rates  in  New 
York  are  higher  in  the  last  3  months  of  the  year  than  in  the  first 
8  or  9  months,  due  to  the  seasonal  demands  for  currency  created 
by  crop  movements.  Deposit  funds  are  withdrawn  from  New 
York  banks  by  banks  in  the  West  and  South  in  order  to  afford 
accommodation  in  the  purchase  of  grain  and  cotton  which  is 
being  harvested  and  marketed.  There  is  consequently  a  flow  to 
the  interior.  As  funds  are  withdrawn,  money  rates  tend  to  stiffen. 
The  following  table  shows  the  rates  on  60-day  time  loans  by 
months  during  the  years  1910-1919: 


XXX] 


THE  NEW  YORK  MONEY  MARKET 


415 


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BANKING  AND  CREDIT 


XXX 


In  every  year  except  two,  191 1  and  19 15,  rates  were  higher  in 
October  than  in  January.  The  reasons  for  these  exceptions  were 
as  follows:  "There  was  no  progress,  no  forward  movement."' 
"There  was  a  superabundance  of  funds  all  through  the  year."^ 
In  191 5  the  volume  of  business  was  enormous  on  account  of 
Europe's  demands  for  war  commodities.  The  large  import  of 
gold  was  used  by  the  federal  reserve  banks  to  strengthen  their 
reserve  position.  Moreover,  under  the  Federal  Reserve  Act, 
which  was  beginning  to  make  its  influence  felt,  the  reserve  re- 
quirements of  member  banks  were  reduced.  This  set  funds  free 
for  loaning  and  the  money  market  was  relieved  from  the  usual 
strain  at  this  period  of  the  year. 

As  a  further  illustration,  the  rates  on  call  loans,  90-day  time 
loans,  and  commercial  paper,  during  191 2  are  presented: 

Rates  on  Call  Loans,  Time  Loans,  and  Commercial  Paper, 
New  York,  1912 


I9I2 

Call  Loans 
(Range) 

Time  Loans. 
90  Days 

(Range) 

Commercial 

Paper,  Double 

Names    60  tfi 

90  Days 

(Range) 

Range   of   Average   Surplus 

Reserve  of  New  York  City 

Clearing  House  Banks 

(Thousands) 

Maximum 

Minimum 

I  3/4-4 

I  3/4-2  1/2 

1  1/2-3 

2  -5 
2  1/4-3 
2         -3 

2         -3  1/2 

2  -3  1/2 

3  -7 

3         -7  1/2 
3         -20 
I  1/2-16 

2  1/4-3  1/2 

2  3/4-3 

3  -3  3/j 
3  1/4-3  3/4 
3         -3  1/4 
3         -3  1/4 
3  1/4-3  3/4 
3  3/4-4  3/4 
5         -6 

5  1/2-6 
5  3/4-6 
5  1/2-6  1/2 

3  1/2-4  1/2 
3  1/2-4 

3  1/2-4  1/2 

4  -4  1/2 
3  3/4-4  1/2 

3  3/4-4  1/4 

4  -43/4 

4  1/2-5 

5  -6 
5  3/4-6 
5  1/2-6 
6 

S43.871 

44.0S7 

24.379 

18,112 

22,054 

27.604 

17.017 

20,890 

6,385 

7,107 

6.220 

7.334 

Feb 

28,668 

5.746 

14 

i2,6g7 

May 

20,343 

*2I3 

July 

Sept 

814 

Oct 

4,578 

*i3r 

Dec 

*70 

*  Deficit,  or  amount  below  the  reserve  requirement. 

^  Ibid.,  p.  IS. 


'  Financial  Review,  1912,  p.  12. 


XXX]        THE  NEW  YORK  MONEY  MARKET         417 

7.  Rate   Changes  Explained. — In  explaining  these  changes, 
The  Financial  Review,  19 13,  comments  as  follows: 

January:  Money  flowed  here  in  enormous  amounts  from  the 
interior.  This  was  due  not  merely  to  the  release  of  funds  used  in 
moving  the  crops,  but  to  the  inactivity  of  general  trade.  Rates 
for  time  loans  reflected  the  redundancy  of  funds  even  more  than 
the  call-loan  branch. 

April:  Call  loan  rates  advanced  to  5  per  cent  at  the  beginning 
of  the  month  incidental  to  the  first  of  April  payments  for  divi- 
dends and  interest  charges  of  depositing  corporations. 

June:  The  undertone  in  money  was  somewhat  firmer.  The 
gold  shipments  to  France  and  the  large  corporation  income 
tax  caused  a  large  reduction  in  the  money  holdings  and  surplus 
reserves  of  the  clearing-house  institutions  the  last  week  of  the 
month.  (It  will  be  observed  that  these  factors  were  reflected  in 
higher  actual  rates  in  July.) 

July:  Money  became  dearer  all  around  during  July.  The 
U.  S.  Treasury  absorbed  large  amounts  of  cash,  there  were  some 
gold  exports  and  the  New  York  Clearing-house  statement  for 
July  6  showed  a  large  deficit.  Surplus  was  restored  the  next 
week  and  the  tone  temporarily  became  easier.  But  this  did 
not  last,  leaders  taking  the  view  that  monetary  conditions  were 
such  as  to  warrant  improved  returns  for  money. 

August:  Money  rates  stiffened  all  around.  Canadian  banks 
suddenly  called  outstanding  demand  loans  on  a  large  scale  and  the 
last  week  of  August  $2,600,000  gold  was  taken  here  for  shipment 
to  Canada.  There  was  renewed  demand  by  Germany  for 
American  loans. 

September:  As  a  result  of  the  large  crops  and  the  expanding 
activity  in  trade,  an  urgent  demand  sprang  up  for  banking  ac- 
commodation and  a  sharp  rise  in  money  rates  ensued.  The 
demand  for  funds  was  increased  by  the  usual  preparations  for  the 
large  interest  and  dividend  disbursements  which  occur  October  i. 

November:  The  interior  demand  for  funds  was  active  and 
there  was  severe  calling  of  loans,  in  view  of  the  first  of  November 
disbursements.  .  .  .  Canadian  banks  withdrew  for  home  use 
considerable  amounts  of  their  funds  held  here,  besides  which 
theie  were  large  requirements  in  connection  with  the  tax  pay- 
ments in  the  city.  .  .  .  The  banks  were  also  expecting  a  call 
27 


4l8  BANKING  AND  CREDIT  [XXX 

of  condition  by  the  Comptroller  of  the  Currency,  and  did  not  care 
to  deplete  their  cash  reserves  in  view  of  such  a  contingency. 

The  foregoing  analysis  relates  to  a  year  before  the  federal 
reserve  system  was  in  operation.  As  already  stated,  the  returns 
of  banks  showing  their  condition  do  not  now  so  clearly  reveal 
the  trend  of  the  money  market,  or  the  forces  which  affect  rates. 
There  is  no  longer  a  close  relationship  between  rates  and  the 
amount  of  the  surplus  reserve  of  member  banks.  This  may  be 
illustrated  by  comments  taken  from  financial  newspapers  and 
bulletins  with  reference  to  the  cause  of  the  money  market  during 
September  and  October,  192 1.  Figures  showing  the  condition  of 
banks  and  money  rates  in  New  York  for  this  period  will  be  found 
on  page  412,  and  should  be  consulted  in  connection  with  this 
analysis. 

In  the  Commercial  and  Financial  Chronicle  for  September  3,  1921,  it  is 
noted  that  the  local  money  market  for  the  week  had  been  "largely  feature- 
less." At  the  beginning  of  the  week  "the  tendency  was  toward  greater 
ease  and  lower  rates.  Call  funds  dropped  to  4>2  per  cent  on  the  Stock 
Exchange  and  to  4  per  cent  in  the  outside  market.  During  the  latter  part 
of  the  period  a  firmer  tone  was  in  evidence  and  ^%  per  cent  was  the  pre- 
vailing rate."  The  time  money  market  continued  nominal  with  quota- 
tions at  534  to  6  per  cent. 

For  the  week  ending  September  10,  the  "money  market  was  devoid  of 
striking  features.  ...  So  far  the  local  money  market  has  not  been  dis- 
turbed by  requirements  in  the  West  and  South  for  moving  the  crops." 
Evidence  appeared  to  show  that  the  grain  movement  was  40  days  ahead 
of  normal  years  and  that  "from  now  on  the  demand  upon  New  York  for 
funds  with  which  to  move  the  crops  probably  will  lessen  rather  than  in- 
crease." No  other  special  demand  was  in  sight,  except  federal  tax  pay- 
ments on  September  15.  Member  banks  wiped  out  the  deficit  in  "surplus 
reserve"  by  borrowings  at  the  federal  reserve  bank  and  there  was  a  slight 
falling  off  in  loans,  "indicating  continued  liquidation." 

In  the  issue  of  September  17,  it  is  noted  that  the  general  trend  of  the 
local  money  market  was  toward  still  greater  ease.  Some  call  money  was 
loaned  at  4>2  per  cent.  In  favor  of  easy  conditions,  it  is  noted  that  the 
gold  reserve  of  the  New  York  Federal  Reserve  Bank  continued  to  increase 


XXX  1  THE  NEW  YORK  MONEY  MARKET  419 

and  that  new  corpoiate  securities  were  finding  a  ready  market.  New 
York  banks  continued  to  gain  currency  from  the  interior.  There  was  a 
large  expansion  in  loans  and  deposits.  The  former  was  attributed  to  dis- 
bursements on  the  third  instalment  of  the  income  taxes,  and  the  latter  to 
payment  by  the  government  of  Liberty  bond  interest. 

iFor  the  week  of  September  24,  though  rates  had  been  irregular,  on  the 
whole  greater  ease  prevailed.  The  New  York  Federal  Reserve  Bank 
lowered  its  discount  rate  to  5  per  cent  and  its  reserve  ratio  advanced  to 
84.1  percent.  As  to  the  future:  "Prominent  bankers  at  this  center  do  not 
fail  to  suggest  that  there  is  still  a  large  volume  of  money  tied  up  in  so- 
called  frozen  credits,  some  of  which  will  not  be  thawed  out  for  some  time 
longer.  They  offer  the  further  suggestion  that  in  spite  of  the  relatively 
low  rates  for  money  now,  it  should  not  be  assumed  that  the  banks  will 
loan  large  sums  for  speculation  in  stocks  01  commodities  in  the  near  future. " 

In  the  week  ending  October  i,  the  rate  on  call  money  rose  to  6  per  cent 
during  one  day,  but  in  general  there  was  little  change  in  the  money  market. 
The  statement  of  the  condition  of  the  New  York  banks,  however,  showed 
the  eHmination  of  the  surplus  reserve  and  a  deficit  of  $10. q  million.  This 
was  due  principally  to  interest  and  dividend  disbursements.  Loans  were 
increased  $55  million  and  demand  deposits  nearly  as  much.  Member 
banks  reduced  their  borrowings  at  the  federal  reserve  bank  by  $3  7 .  i  million. 
"These  changes,  however,  attracted  only  perfunctory  notice  as  they  are 
regarded  as  only  bookkeeping  transactions  and  almost  certain  to  be  read- 
justed in  the  course  of  another  week." 

In  commenting  upon  credit  conditions  for  the  month  as  a  whole,  the 
Monthly  Review  for  October  i,  published  by  the  Federal  Reserve  Agent 
of  the  New  York  Reserve  Bank,  observes: 

"The  reduction  of  discount  rates  of  the  New  York  Reserve  Bank  on 
September  22  was  a  reflection  of  existing  credit  conditions  in  this  Federal 
Reserve  district.  More  particularly,  it  was  a  reflection  of  easier  conditions 
in  the  money  market.  Evidences  of  the  tendency  toward  lower  rates  for 
money  included  the  sale  on  September  15  of  $698,000,000  of  Treasury 
certificates  and  notes  at  rates  lower,  for  corresponding  maturities,  than 
at  any  time  since  IMarch,  1920.  .  .  .  These  lower  rates  of  return  on 
investments  of  complete  security  and  the  readiest  sale  are  the  best  indices 
at  this  time  of  market  rates  for  money." 

For  the  week  ending  October  8,  it  is  noted  in  the  Chronicle  that  the 
general  trend  of  the  money  market  is  toward  greater  ease.  Call  money 
rates  ranged  from  4J^  to  $}4  per  cent  and  mercantile  paper  rates  were  a 
shade  easier.    As  anticipated  in  the  previous  week,  the  deficit  in  the  re- 


420  BANKING  AND  CREDIT  [  XXX 

serve  of  member  banks  was  extinguished  by  borrowings  at  the  federal 
reserve  bank.  Reference  is  made  to  the  large  issues  of  new  bonds,  but 
notwithstanding  this  employment  of  funds  "the  prevailing  opinion  ap- 
pears to  be  that  the  money  market  will  be  easy  for  some  time  to  come. 
.  .  .  Asaraatterof  fact,  no  one  can  do  much  more  than  venture  a  guess, 
because  of  the  many  uncertainties  in  the  general  situation.  If  business 
should  improve  rapidly,  as  is  forecast  by  some  authorities,  there  would  be  a 
free  demand  for  funds.  This,  coupled  with  requirements  abroad,  might 
bring  about  a  fairly  firm  money  market." 

For  the  week  of  October  15,  call  money  rates  were  slightly  firmer. 
This  is  attributed  to  preparation  for  government  tiansactions  and  to 
interest  and  dividend  payments  by  corporations.  "Today  the  New  York 
Federal  Reserve  Bank  will  pay  to  local  depositories  $1 25,000,000  on  matur- 
ing Treasury  certificates  of  indebtedness,  and  an  additional  $17,000,000 
for  interest  on  Liberty  bonds.  On  the  other  hand  the  government  will 
withdraw  from  local  institutions  $117,000,000.  During  the  first  half  of 
next  week  it  is  assumed  that  the  greater  part  of  these  funds  will  find  their 
way  back  into  regular  channels."  Notwithstanding  the  large  increase  in 
deposits,  the  reserve  was  increased  by  further  borrowings  at  the  reserve 
bank. 

In  the  week  of  October  22  the  money  market  was  "decidedly  easier." 
The  advance  in  the  reserve  ratio  of  the  New  York  Federal  Reserve  Bank 
from  77  to  83  per  cent  "attracted  special  attention."  "Borrowers  on 
time  found  ofTerings  freer."  The  combined  statement  of  condition  of 
banks  again  shows  that  the  surplus  reserve  figure  is  regarded  as  of  little 
significance.  Demand  deposits  were  increased  $77,000,000  requiring  a 
larger  reserve.  As  the  banks  decreased  their  borrowings  at  the  federal 
reserve  bank  there  was  a  deficit  in  the  reserves. 

A  week  later  (ending  October  29)  call  money  rates  were  higher.  The 
reason  for  this  was  not  clear.  "Little  has  been  published  to  explain  the 
higher  tendency  of  all  money.  The  withdrawals  by  the  government  have 
not  been  large,"  and  financing  for  private  corporations  was  not  "particu- 
larly striking." 

8.  The  New  York  Call  Money  Market. — Occasionally  the 
rates  on  call  money  in  New  York  City  are  very  high,  15  or  20 
per  cent,  or  even  higher.  This  may  create  distrust  and  alarm. 
Frequently  such  high  rates  are  not  a  true  index  of  the  trend  of  the 
money  market,  but  represent  the  charges  made  to  belated  bor- 


XXX]        THE  NEW  YORK  MONEY  MARKET         42 1 

rowers  from  the  stock  exchange  who  need  funds  at  once  to  settle 
unexpected  adverse  balances.  A  call  rate  of  15  per  cent  on  a 
given  day  does  not  mean  that  all  borrowers  on  call  paid  that  rate. 
The  rate  may  have  been  applied  to  but  a  very  few  and  for  only  a 
very  short  time.  The  high  call  money  rate  as  a  rule  applies  only 
for  a  single  day,  as  the  next  day  the  loan  is  renewed  at  the  re- 
newal rate,  which  is  much  lower.  Exceptionally  high  rates  are 
incident  to  stock-exchange  operations  which  require  daily  settle- 
ments, and  do  not  necessarily  reflect  the  probable  rates  for  time 
loans  or  discounts  on  commercial  paper.  Because  of  the  wide- 
spread public  misunderstanding  of  the  significance  of  call  money 
rates,  the  Senate  in  March,  1920,  asked  the  Federal  Reserve 
Board  to  report  on  the  "cause  and  justification  for  usurious  rates 
of  interest  on  collateral  call  in  the  financial  centers."  According 
to  the  reply  made  by  the  Federal  Reserve  Board  present  practice 
may  be  summarized  as  follows:-^ 

Collateral  call  loans,  in  the  general  acceptance  of  the  term,  are 
made  chiefly  in  New  York  City,  which  is  practically  the  only 
important  call  money  market  in  this  country.  These  loans  are 
secured  by  the  pledge  of  investment  securities,  i.e.,  stocks  and 
bonds,  generally  those  which  are  dealt  in  on  the  New  York  Stock 
Exchange.  The  loans  are  made  for  the  most  part  to  houses  which 
are  members  of  the  stock  exchange,  and  the  money  so  borrowed 
constitutes  a  portion  of  the  funds  employed  ordinarily  in  purchas- 
ing and  carrying  securities  for  their  customers  and  sometimes  for 
themselves.  The  bulk  of  call  money  is  lent  on  the  floor  of  the 
New  York  Stock  Exchange  at  the  "money  post,"  where  through 
various  brokers  loanable  funds  are  offered  and  bids  for  funds  are 
received.  Most  of  the  business  is  done  between  the  hours  of  12 
noon  and  2:45  p.m. 

9.  Sources  of  Call  Money. — The  principal  supplies  of  money 
for  collateral  call  loans  are  loanable  funds  of  banks  and  bankers 


3  Federal  Reserve  Bulletin,  April  1920,  pp.  368-372. 


422  BANKING  AND  CREDIT  [  XXX 

located  both  in  and  outside  of  New  York  City,  including  foreign 
banks  and  agencies  of  foreign  banks,  and  similarly  the  loanable 
funds  of  firms,  individuals,  and  corporations  seeking  temporary 
investment.  In  the  matter  of  the  supply  or  attraction  of  funds 
to  the  call  money  market,  there  is  generally  a  definite  and  well- 
understood  obligation  on  the  part  of  banks  to  accommodate  first 
their  own  commercial  clients,  so  that  it  is  only  the  excess  of  loan- 
able funds  which  they  may  have  from  time  to  time  that  is  avail- 
able for  the  collateral  call  money  market,  or  for  the  purchase  of 
commercial  paper  in  the  open  market.  This  excess  of  loanable 
funds  available  for  employment  in  the  securities  market  varies, 
therefore,  according  to  the  commercial  requirements  of  the  country. 
The  idea  that  when  call  money  rates  are  high,  say,  at  25  to 
30  per  cent,  all  banks  are  investing  in  that  manner  and  receiving 
abnormal  rates  is  erroneous.  In  fact  one  of  the  reasons  for  the 
high  call  rates  is  that  money  is  going  largely  to  commercial  bor- 
rowers, and  the  brokers  for  that  reason  are  compelled  to  bid  high 
for  accommodation. 

10.  Former  Place  as  Secondary  Reserve. — Prior  to  the  insti- 
tution of  the  federal  reserve  system,  bankers,  especially  in  reserve 
centers,  were  accustomed  to  look  upon  call  loans  as  their  principal 
secondary  reserve,  on  the  theory  that  inasmuch  as  those  loans 
were  payable  on  demand,  the  invested  funds  could  always  be 
promptly  obtained  on  short  notice  to  meet  withdrawals  of  de- 
posits or  for  other  use.  Consequently  there  was  available  for  col- 
lateral call  loans  a  supply  of  funds  sufficient  for  ordinary  market 
requirements  and  at  low  rates,  although  at  times  the  rates  rose 
to  high  levels  as  the  supply  of  funds  diminished,  or  the  demands 
increased. 

The  traditional  attitude  of  banks  toward  call  loans  as  their 
chief  secondary  reserve  has  been  greatly  modified  by  two  causes. 
The  first  resulted  from  the  closing  of  the  stock  exchange  at  the 
outbreak  of  the  European  war  in  the  summer  of  191 4,  when  it 


XXX  ]  THE  NEW  YORK  MONEY  MARKET  423 

became  practically  impossible  to  realize  on  call  loans  secured  by 
investment  securities,  which  became,  therefore,  "frozen  loans." 
This  brought  about  a  more  or  less  permanent  prejudice  against 
dependence  upon  call  loans  as  secondary  reserves.  The  second 
and  more  important  factor  was  the  creation  of  the  federal  reserve 
system. 

Under  the  terms  of  the  Federal  Reserve  Act  provision  is  made 
for  the  rediscount  of  commercial  paper,  but  the  rediscount  of  loans 
for  the  purpose  of  carrying  investment  securities,  other  than 
United  States  government  obligations,  is  excluded.  Conse- 
quently in  order  to  maintain  maximum  liquidity,  with  suitable 
provision  for  secondary  reserves  that  can  be  immediately  availed 
of,  banks,  including  foreign  agency  banks,  now  invest  a  greater 
proportion  of  their  resources  in  assets  that  can  be  realized  upon  at 
the  federal  reserve  bank.  Another  changed  factor  in  the  present 
situation  grows  out  of  the  fact  that  the  war  and  post-war  condi- 
tions have  rendered  unavailable  supplies  of  money  which  for- 
merly came  from  foreign  banks. 

II.  War  Regulation  of  Money  Market. — During  the  latter 
part  of  the  war,  agencies  of  the  government  were  employed  to 
restrict  the  issue  of  new  securities  for  purposes  other  than  those 
which  were  deemed  essential.  Moreover,  as  the  Treasury  under- 
took to  sell  large  amounts  of  certificates  of  indebtedness  and 
Liberty  bonds  bearing  low  rates  of  interest,  the  question  arose 
as  to  whether  the  competition  of  the  general  investment  market 
might  not  prejudice  the  success  of  the  government  issues.  In 
these  circumstances,  with  full  understanding  on  the  part  of  the 
Treasury  Department,  the  officers  and  members  of  the  New  York 
Stock  Exchange  undertook  to  limit  transactions  which  would 
involve  the  increased  use  of  money  for  other  purposes,  in  con- 
sideration of  which  the  principal  banks  of  New  York  City  en- 
deavored to  provide  a  stable  amount  of  money  for  the  require- 
ments of  the  securities  market. 


424  BANKING  AND  CREDIT  [  XXX 

After  the  armistice  these  restrictions  were  removed  and  ordi- 
nary market  forces  reasserted  themselves.  The  issuance  of  new 
securities  was  resumed  in  unprecedented  volume  and  consumed 
a  vast  amount  of  capital  and  credit  when  bank  credit  was  already 
expanded  by  the  necessity  of  carrying  large  amounts  of  govern- 
ment securities  which  the  investment  market  was  not  prepared 
to  absorb. 

12.  Renewal  Rate  on  Call  Loans. — The  renewal  rate,  or  the 
rate  at  which  loans  not  called  for  payment  bear  interest  until  the 
following  day,  is  regarded  as  the  real  barometer  of  market  condi- 
tions, and  its  fluctuations  throughout  the  longer  periods  indicate 
more  significantly  the  relation  between  the  supply  and  demand  of 
loanable  funds. 

The  renewal  rate  is  fixed  about  11:30  a.m.  each  day  by  the 
president  of  the  exchange  after  consulting  with  the  money- 
brokers  and  certain  officials,  and  is  based  upon  the  approximate 
rate  for  that  day  and  the  probable  demand  for  money  before  the 
rate  is  set  again.  When  money  is  scarce  the  renewal  rate  is 
sometimes  set  higher  than  the  prevailing  interest  rates,  partly  for 
the  purpose  of  attracting  funds.  Not  infrequently  it  is  found  that 
the  renewal  rate  has  been  placed  too  high,  for  very  shortly  new 
loans,  which  of  course  do  not  bear  the  renewal  rate,  are  made  at 
a  lower  figure.  Interior  bankers  often  complain  about  being  dis- 
criminated against  because  their  funds  are  not  loaned  by  their 
New  York  correspondents  at  the  highest  rates  for  the  day.  Such 
complaints  for  the  most  part  are  not  based  on  the  facts  of  the  case 
for  several  reasons.  As  a  general  rule  the  great  bulk  of  the  money 
loaned  on  call  bears  the  renewal  rate  from  day  to  day  and  only  a 
very  small  proportion  gets  the  high  rates  quoted.  Late  in  the 
afternoon  where  the  renewal  rate  for  the  day  is  possibly  6  or  8 
per  cent,  the  rate  for  new  loans  often  goes  to  1 2  or  15  per  cent  or 
even  higher,  largely  because  the  banks'  loanable  funds  for  the 
day  have  been  exhausted  and  no  additional  money  is  forthcoming. 


XXX  1  THE  NEW  YORK  MONEY  MARKET  425 

13.  Influence  of  Call  Money  Rates  on  Business. — The  rates 
for  call  money  do  not  determine  and  have  not  exerted  an  impor- 
tant influence  on  the  rates  for  commercial  borrowings.  This  is 
to  be  explained  by  the  universal  custom  of  banks  to  satisfy  first 
the  commercial  needs  of  their  customers.  Banks  feel  an  obliga- 
tion to  customers  but  not  to  those  who  borrow  in  the  open  market 
on  securities.  Furthermore,  as  the  resources  of  the  banks  mainly 
come  from  the  commercial  customers,  their  own  self-interest 
compels  a  preference  in  favor  of  their  commercial  borrowers, 
since  failure  to  grant  reasonable  accommodation  would  induce 
them  to  withdraw  their  deposits  and  so  reduce  the  abiUty  of  the 
banks  to  do  business. 

An  attempt  to  control  the  rates  for  call  loans  by  the  estabHsh- 
ment  of  an  arbitrary  limit  at  a  low  level  would  be  distmctly 
hazardous,  for  the  reason  that  up  to  the  point  where  the  arbitrary 
rate  would  limit  the  supply  of  new  money,  speculation  and  ex- 
pansion might  proceed  unchecked  and  the  natural  elements  of 
correction  or  regulation  would  not  obtain.  In  other  words,  high 
rates  act  as  a  deterrent  to  overspeculation  and  undue  expansion 
of  credit.  What  is  more,  high  call  money  rates  attract  funds  from 
interior  points,  and  to  fix  arbitrarily  the  rates  below  their  real 
competitive  market  level  would  simply  mean  a  smaller  amount 
of  available  funds  for  loans.  Again,  a  supply  of  money  avail- 
able at  a  fixed  maximum  might  become  exhausted  and  liquida- 
tion might  suddenly  become  forced,  because  the  demands  for 
additional  accommodation  for  the  fulfilment  of  commitments 
already  made  could  not  be  met.  As  an  example  of  the  effect  of 
such  liquidation  upon  dealers  and  merchants  in  commodities,  the 
case  might  be  cited  of  a  commitment  to  purchase  a  round  amount 
of  cotton  on  a  certain  day.  Many  of  the  houses  on  the  cotton 
exchange  are  also  members  of  the  stock  exchange  and  frequently 
borrow  very  largely  on  the  stock  exchange  to  provide  funds 
against  settling  their  transactions  in  cotton.  If,  therefore,  an 
important  cotton  settlement  is  imminent,  and  borrowings  on 


426  BANKING  AND  CREDIT  [  XXX 

securities  could  not  be  availed  of,  the  cotton  transaction  could 
not  be  carried  out  and  a  drastic  liquidation  through  sale  either  of 
securities  or  of  the  cotton  might  be  required  to  avoid  default. 

References 

The  Commercial  and  Financial  Chronicle  (weekly). 

Gives  current  analyses  and  explanations  of  the  money  market; 
also  contains  editorial  paragraphs  and  descriptions  of  the  principal 
changes  of  the  week. 
Federal  Reserve  Bulletin  (monthly). 

Contains  tables  showing  discount  rates  and  interest  rates  in  the 
various  centers  throughout  the  United  States. 
Huebner,  S.  S.    The  Stock  Market,     pp.  295-305. 
Meeker,  J.  E.     Work  of  the  Stock  Exchange.    Chapter  8. 
Moulton,  H.  G.     Financial  Organization  of  Society. 

Call  loans  and  stock-brokers,  pp.  391-394. 
Pratt,  S.S.    The  Work  of  Wall  Street.    Chapter  20. 


CHAPTER  XXXI 

MONETARY   PROBLEMS 

I.  Controversies  in  Regard  to  Money  and  Banking. — Promi- 
nent among  the  many  questions  of  economic  interest  which  have 
aroused  during  the  past  century  widespread  public  discussion  in 
the  United  States,  and  at  times  violent  partizan  agitation,  have 
been  those  relating  to  money  and  banking.  In  the  first  half  of 
the  last  century  banking  policies  occupied  the  center  of  the  stage; 
in  the  latter  part  of  the  century  the  nature  of  the  monetary  me- 
dium and  its  volume.  Early  in  the  nineteenth  century  a  struggle 
took  place  over  the  renewal  of  the  charter  of  the  First  United 
States  Bank.  An  attack  was  made  on  the  ground  that  the  bank 
was  an  undemocratic  political  institution,  that  it  centralized  the 
power  of  the  federal  government  at  the  expense  of  state  preroga- 
tives and  local  banks,  and  that  the  large  holdings  of  capital  by 
foreign  stockholders  menaced  the  independence  of  the  United 
States. 

The  Second  United  States  Bank  (1816-1836)  had  a  stormy 
career.  At  the  outset  it  had  to  contend  with  the  rivalries  of  local 
banks;  later  in  Jackson's  administration  the  question  of  renewing 
its  charter  became  a  national  issue.  Again  opposition  was  in- 
spired by  the  fear  of  a  money  monopoly.  There  were  also  con- 
tests in  different  states  over  questions  of  banking  policy.  On  the 
one  side  was  the  effort  in  undeveloped  communities  lacking  capi- 
tal to  secure  a  larger  command  of  credit.  Frequently  this  led  to 
the  establishment  of  weak  institutions,  the  overissue  of  notes, 
and  reckless  speculation.  In  opposition  was  the  conservative 
desire  to  avoid  these  evils,  and  this  was  reinforced  by  a  suspicion 
of  money  interests  which  might  through  banking  institutions 
impose  heavy  burdens  upon  industry  and  agriculture.    The  early 

427 


428  BANKING  AND  CREDIT  |  XXXI 

development  of  banking  was  thus  constantly  attended  by  dis- 
trust, bitter  debate,  and  frequently  by  reversals  of  financial 
policy. 

After  the  Civil  War  public  discussion  was  concerned  with 
questions  relating  to  money  rather  than  with  banking  organiza- 
tion. In  particular  there  was  prolonged  controversy  over  the 
issue  of  promissory  notes  or  greenbacks  by  the  government,  and 
over  the  coinage  of  silver.  As  the  legislation  following  these 
contests  has  left  its  impress  upon  our  credit  system,  these  topics 
require  explanation. 

2.  Issue  of  Government  Notes. — The  Constitution  is  silent 
as  to  the  power  of  Congress  to  authorize  the  issue  of  bills  of  credit 
or  government  non-interest  promissory  notes  with  no  specific 
date  of  maturity.  Experience  with  such  notes,  known  as  "con- 
tinental currency,"  during  the  Revolutionary  period  had  been 
disastrous,  and  the  convention  which  framed  the  Constitution 
decided  to  strike  out  a  proposed  clause  conferring  this  power. 
Although  the  decision  was  adverse  to  positive  authority,  their 
issue  is  not  specifically  prohibited.  Twenty-five  years  later  when 
the  government  was  in  need  of  funds  to  carry  on  the  war  with 
England,  issues  of  treasury  notes  were  made.  These  were  re- 
garded as  emergency  notes,  in  anticipation  of  revenue,  and  as  soon 
as  the  war  was  over  were  quickly  funded  into  long-term  bonds. 
Of  the  five  issues  made  at  this  time,  four  bore  interest,  and  none 
were  made  legal  tender.  As  nearly  all  the  notes  were  in  large 
denominations,  they  were  not  designed  to  go  into  general  circula- 
tion to  become  a  part  of  currency. 

At  later  periods  Congress  resorted  to  this  financial  expedient 
to  secure  funds  when  the  Treasury  was  hard  pressed,  as  during 
the  years  183  7- 1843,  occasioned  by  the  panic  of  1837;  in  the  war 
with  Mexico  (1846) ;  and  in  the  panic  of  1857.  ^11  o^  these  notes 
bore  interest  and  none  of  them  were  given  a  legal  tender 
quaHty. 


XXXI]  MONETARY  PROBLEMS  429 

3.  Legal  Tender  Issues  of  Civil  War. — As  a  result  of  the  over- 
whelming financial  demands  made  upon  the  Treasury  during  the 
Civil  War,  Congress  not  only  authorized  the  issue  of  notes  but 
swept  aside  all  the  restrictions  which  had  been  attached  to  pre- 
vious issues.    It  was  argued  that  the  government  should  not  be 
dependent  upon  banks  or  loans;  rather  it  should  assert  its  power 
and  dignity  by  the  issue  of  its  own  notes :    "To  render  the  govern- 
ment financially  more  independent,  it  is  necessary  to  make  the 
United  States  notes  a  legal  tender."    This  view  prevailed,  and 
Congress,  by  the  act  of  February  25,  1862,  authorized  the  issue 
of  $150  million  non-interest  legal  tender  notes.     Similar  issues 
were  authorized  in  July  of  the  same  year  and  in  1863,  making  in 
all  $450  million.    At  first  these  notes  could  be  converted  into 
bonds,  but  this  privilege  was  quickly  rescinded.    In  1865,  at  the 
close  of  the  war,  $433.1  million  were  outstanding  in  circulation. 
It  is  difficult  to  determine  how  far  the  issue  of  the  greenbacks 
contributed  to  the  derangement  of  prices  and  depreciation  of  the 
currency.    Specie  payments  were  suspended  early  in  the  war,  and 
gold  went  to  a  premium.    A  considerable  part  of  the  government 
loans  was  in  the  form  of  short-term  treasury  notes  (not  legal 
tender)  which  circulated  to  some  extent  as  money,  and  there  was 
an  expansion  in  local  bank  note  issues.     Each  of  these  factors 
contributed  to  inflation.    In  1862  the  value  of  the  paper  dollar 
as  measured  in  gold  fell  to  76  cents,  in  1863  to  62  cents,  and  in 
1864  to  39  cents.    At  the  close  of  the  war  it  was  about  70  cents. 

When  peace  returned  it  was  generally  assumed  that  the  green- 
back issues  would  be  retired,  but  opposition  quickly  arose  to  any 
contraction  of  the  currency.  Some  opposed  because  the  redemp- 
tion of  the  notes  would  require  additional  tax  burdens,  and  others 
because  of  the  difficulty  in  securing  gold  to  be  used  for  redemp- 
tion of  the  notes.  These  views  were  soon  supplemented  by  the 
demand  that  the  currency  should  be  expanded  instead  of  con- 
tracted. "Our  currency,  as  well  as  everything  else,  must  keep 
pace  with  our  growth  as  a  nation,"  declared  a  member  of  Congress. 


430  BANKING  AND  CREDIT  [  XXXI 

It  was  urged  that  contraction  would  reduce  prices  and  that  this 
would  be  injurious  to  business.  Debts  had  been  assumed  on  the 
basis  of  high  prices,  and  it  would  be  disastrous  to  force  the  debtors 
to  pay  in  a  dearer  currency.  Influenced  by  such  arguments,  only 
a  small  amount  of  contraction  was  effected — $44,000,000  being 
retired.  In  1868  any  further  contraction  was  prohibited  by 
Congress. 

4.  Constitutionality  of  Issues. — In  the  meantime  the  question 
of  the  constitutionality  of  legal  tender  notes  was  raised.  In 
1869  the  Supreme  Court  decided  adversely  in  a  divided  opinion, 
four  to  three.  This  decision  created  great  dissatisfaction  and  a 
new  case  was  brought  before  the  court  in  1871.  The  membership 
of  the  court  was  changed  during  the  two  intervening  years  by  the 
appointment  of  two  additional  justices,  and  on  this  occasion  the 
court  sustained  the  constitutionality  of  the  issue.  "What  we  do 
assert  is,  that  Congress  has  power  to  enact  that  the  government's 
promises  to  pay  money  shall  be,  for  the  time  being,  equivalent  in 
value  to  the  representation  of  value  determined  by  the  coinage 
acts  or  to  multiples  thereof."  A  third  decision  a  few  years  later 
justified  the  exercise  of  this  sovereign  power  in  times  of  peace  as 
well  as  during  an  emergency  created  by  war. 

It  was  not  until  1875  that  Congress  took  a  decisive  step  to 
provide  for  a  restoration  of  the  depreciated  currency  to  its  value  at 
par  in  gold;  and  resumption  was  finally  achieved  in  1879.  By  the 
act  of  1875,  it  was  intended  that  the  greenback  issues  should  be 
reduced  to  $300,000,000,  but  those  who  advocated  inflation  were 
strong  enough  in  1878  to  enact  legislation  forbidding  any  further 
contraction  of  greenbacks.  At  that  time  there  were  $346,681,016 
of  these  notes  outstanding,  and  from  that  date  the  same  amount 
has  been  carried  as  one  of  the  liabilities  of  the  Treasury.  Occa- 
sionally it  has  been  proposed  that  the  notes  be  retired,  and  that 
the  government  free  itself  from  any  further  responsibility  for  the 
issue  of  bills  of  credit  with  the  legal  tender  attribute.  Time,  how- 


XXXI]  MONETARY  PROBLEMS  431 

ever,  has  confirmed  their  use,  and  as  they  form  but  a  small 
portion  of  the  currency  and  enjoy  popular  confidence,  they  are 
universally  acceptable  and  are  likely  to  remain  in  circulation  for 
an  indefinite  period. 

5.  The  Adoption  of  the  BimetaUic  System  in  1792. — The  first 
coinage  act  of  1792  established  the  bimetallic  system  with  a  mint 
ratio  of  I  to  15  between  gold  and  silver.  Within  a  few  years, 
however,  gold  was  worth  more  in  terms  of  silver  than  was  recog- 
nized by  the  mint  valuation,  and  consequently  there  was  but 
little  coinage  of  that  metal.  In  1834  that  deviation  was  remedied 
by  changing  the  mint  ratio  to  approximately  i  to  1 6 .  This  proved 
satisfactory  for  a  few  years,  but  after  the  gold  discoveries  in 
Cahfornia  and  Australia,  beginning  about  the  middle  of  the  cen- 
tury, gold  fell  in  value.  In  other  words,  silver  rose  in  value  and 
was  worth  more  in  the  bullion  market  than  at  the  mint.  Silver 
therefore  was  not  coined. 

The  stoppage  of  the  coinage  of  silver  dollars  did  not  create 
any  serious  inconvenience,  for  the  state  banks  were  able  to  furnish 
notes  in  small  denominations,  which  served  the  ordinary  needs  of 
retail  trade  and  industry.  The  disappearance  of  the  small  silver 
coins  in  denominations  of  less  than  $1  was,  however,  a  more  ser- 
ious matter,  for  banks  did  not  issue  notes  in  fractional  parts  of  the 
dollar.  To  meet  this  difficulty.  Congress  lowered  the  weight  of 
the  subsidiary  coins  and  thus  made  it  unprofitable  to  melt  the 
coins  for  sale  as  bullion.  Silver  dollars,  however,  went  out  of 
circulation  and  were  unfamiliar  to  the  generation  living  between 
1850  and  1878. 

6.  Demonetization  of  Silver  in  1873. — In  1873  the  coinage 
laws  were  revised  and  in  the  act  as  finally  passed  no  reference  to 
the  coinage  of  silver  dollars  was  made.  As  these  coins  were  not 
in  circulation  at  the  time,  the  omission  did  not  attract  attention. 
The  discovery  of  new  silver  mines  in  Colorado  quickly  aroused 


432  BANKING  AND  CREDIT  [XXXI 

inquiry,  for  the  owners  of  the  mines  found  that  there  was  no 
provision  for  disposing  of  their  product  at  the  mint.  Moreover, 
the  bulhon  value  of  silver  was  falling.  Germany  had  recently 
changed  from  a  bimetallic  to  a  single  gold  standard,  and  to  carry 
this  out  the  German  government  sold  a  large  amount  of  the  dis- 
carded silver  and  this  lowered  the  price.  The  mining  interests 
of  the  West  promptly  demanded  that  silver  be  restored  to  coin- 
age and  be  remonetized.  This  demand  was  reinforced  by  other 
groups  of  inflationists  who  complained  that  the  fall  in  commodity 
prices,  accompanying  the  readjustment  of  industry  after  the 
Civil  War,  was  occasioning  great  hardship.  Particularly  was  this 
true  of  those  who  were  in  debt,  as,  for  example,  farmers  in  the 
purchase  of  land.  All  classes  who  favored  a  high  level  of  prices 
joined  together,  not  only  to  prevent  the  contraction  of  the  green- 
backs, but  also  to  re-establish  the  free  coinage  of  silver. 

7.  Silver  Purchase  Acts. — The  agitation  became  extremely 
bitter.  The  omission  of  silver  dollars  from  the  act  of  1873  was 
declared  to  be  a  premeditated  plot  which  was  planned  by  the 
creditor  class,  who  profited  by  low  prices.  The  "  Crime  of  1873" 
was  denounced  in  heated  campaign  speeches.  Congress  went  so 
far,  in  1875,  as  to  recognize  the  silver  dollar  as  legal  tender  money, 
but  made  no  provision  for  its  coinage.  Three  years  later  silver 
won  a  partial  victory.  The  Bland  Act  authorized  the  purchase 
and  coinage  of  a  limited  amount  of  silver — at  least  $2,000,000 
and  not  more  than  $4,000,000  per  month. 

The  new  silver  coins  were  not  favored  in  the  East;  individuals 
regarded  them  as  cumbersome,  and  banks  in  some  cities  endeav- 
ored to  cast  discredit  upon  them  by  refusing  to  accept  them  in 
settling  clearing-house  balances.  This  was  futile,  for  the  coins 
were  legal  tender.  In  order  to  utilize  the  new  coins  as  currency, 
Congress  authorized  the  issue  of  silver  certificates  upon  deposit  of 
silver  coins,  and  this  form  of  representative  money  largely  took 
the  place  of  the  coins  in  the  northeastern  section  of  the  country. 


XXXI 1  MONETARY  PROBLEMS  433 

The  silver  party  still  continued  active;  in  1890  it  won  another 
victory  in  the  Sherman  Act,  which  provided  for  the  purchase  of 
54,000,000  ounces  of  silver  annually.  Instead  of  immediate  coin- 
age, however,  the  Treasury  was  authorized  to  hold  the  silver 
bullion  and  issue  treasury  notes  against  this  metal  security. 
Only  when  the  treasury  notes  were  presented  for  redemption  was 
the  silver  to  be  coined  into  dollars.  Success  was  short-lived; 
there  was  alarm  over  the  ability  of  the  government  to  maintain 
specie  payments  and  the  act  was  repealed  in  1893. 

The  advocates  of  silver  did  not  accept  this  defeat.  The  fall 
of  prices  was  world-wide  and  other  nations  were  disturbed  by 
popular  discontent  due  to  the  unsettlement  of  values.  Efforts 
were  made  to  secure  international  bimetallism  by  common  action 
of  the  more  important  commercial  nations.  While  the  free  silver 
party  welcomed  support  from  any  source,  it  insisted  that  this 
country  should  not  wait  for  the  consent  of  other  nations.  Rather 
it  should  proceed  independently.  No  respect  was  given  to  the 
argument  that,  if  the  United  States  alone  authorized  the  free 
coinage  of  silver  at  a  ratio  of  i  to  16  when  the  market  ratio  was 
I  to  30,  gold  would  disappear  from  circulation  and  that  this  coun- 
try would  practically  be  placed  upon  a  single  silver  standard. 
Contracts  of  indebtedness  based  upon  a  standard  of  gold  would 
be  disturbed  if  settlement  could  be  made  in  a  silver  dollar  worth 
only  50  cents  in  gold,  and  exchanges  with  countries  which  main- 
tained the  gold  standard  would  be  subject  to  the  continuous 
fluctuations  in  the  relative  value  of  the  two  metals.  The  presi- 
dential campaign  of  1896  was  waged  upon  this  issue;  the  free 
silver  party  was  defeated. 

Although  there  was  an  occasional  renewal  of  interest  in  silver 
coinage,  the  movement  had  spent  its  force.  There  was  a  turn  in 
the  price  level.  Prices  slowly  began  to  rise,  and  the  revival  of 
industry  in  the  closing  years  of  the  century  destroyed  the  force 
of  the  arguments  which  had  sustained  the  silver  cause  for  so 
many  years. 
28 


434  BANKING  AND  CREDIT  [XXXI 

8.  Demand  for  Inflation. — In  each  of  the  two  controversies 
which  have  been  briefly  described,  it  has  been  noted  that  the  change 
in  the  price  level  was  a  powerful  influence  in  provoking  agitation. 
They  both  arose  when  the  change  was  downward  and  the  agitation 
was  directed  in  favor  of  an  expansion  or  inflation  of  the  currency. 

The  arguments  rested  upon  the  assumption  that  prices  are 
determined  by  the  volume  of  money.  If  there  be  a  larger  supply 
of  money,  prices  will  be  higher ;  if  smaller,  prices  will  be  lower.  In 
each  case,  however,  the  agitation  was  devoted  to  increasing  the 
supply  of  a  particular  kind  of  money,  regardless  of  the  effects 
which  this  would  have  upon  the  monetary  system  as  a  whole. 
An  increase  in  greenbacks  would  not  necessarily  increase  the 
total  mass  of  money,  for  both  theory  and  experience  show  that  if 
one  form  of  money  be  increased  in  excess  of  public  confidence, 
the  other  forms  of  money,  in  which  there  is  general  confidence 
and  for  which  there  is  general  acceptability,  will  tend  to  disappear 
from  circulation .  If  greenbacks  had  been  freely  issued  beyond  the 
ability  of  the  government  to  redeem  them  in  gold,  the  monetary 
standard  would  no  longer  be  gold,  but  government  promissory 
notes.    The  result  would  be  a  paper  standard. 

So,  too,  in  the  case  of  silver.  If  silver  were  freely  coined  and 
the  public  lost  confidence  in  the  ability  of  the  government  to 
redeem  it  in  gold,  gold  would  disappear  from  circulation.  In 
each  case  gold  would  be  valued  more  than  the  greenbacks  or  the 
silver;  it  would  consequently  be  valued  at  a  premium.  It  might 
remain  in  the  country  but  it  would  be  held  simply  as  a  commodity 
and  its  price  determined  like  other  commodities,  by  the  current 
supply  and  demand.  The  advocates  of  greenbacks  and  of  free 
silver  paid  little  heed  to  such  considerations;  they  were  bent  upon 
the  increase  of  one  particular  kind  of  currency,  irrespective  of  its 
influence  upon  the  total  volume. 

Q.  Index  Numbers. — Changes  in  prices  are  conveniently 
shown  by  the  use  of  index  numbers.    An  index  number  when 


XXXI 


MONETARY  PROBLEMS 


435 


applied  to  prices  in  its  simplest  form  "is  the  price  of  a  composite 
commodity  unit,  representing  approximately  the  average  price 
of  commodities  in  general." '  Such  a  number  for  a  given  year  by 
itself  has  little  significance,  but  when  compared  with  similar 
units  for  other  years  shows  the  changes  which  have  taken  place 
in  the  prices  of  commodities  as  a  whole.  Many  methods  have 
been  decided  for  computing  price  index  numbers,  but  the  result- 
ant figures  do  not  show  great  differences.  The  more  common 
method  is  to  select  a  given  year  or  short  period  of  years  as  a  base, 
represented  by  loo,  and  calculate  the  figures  for  other  years  in 
percentages  of  the  base  year.  For  example,  suppose  that  the 
following  prices  are  given : 


Year 

Cattle 
(100  lb.) 

Cotton 
(lb.) 

Coal, 

Anthracite 
Chestnut 
(2,240  lb.) 

Steel, 

Structural 

(lb.) 

19 1 3 
1917 
1918 
1919 
1920 

$8,507 
12.560 
17.625 
16.869 
i5-3«i 

$0,128 
.261 
.312 

•351 
.410 

$5-313 
5-933 
6.693 
8.304 
9-551 

$0,016 
.062 

•033 
.027 
.032 

If  the  prices  for  19 13  be  taken  as  the  base  for  comparison, 
expressed  as  100,  and  the  prices  for  the  succeeding  years  be  com- 
puted in  terms  of  percentages,  the  following  table  is  derived: 


Year 

Cattle 
(100  lb.) 

Cotton 

(lb.) 

Coal, 
Anthracite 
Chestnut 
(2,240  lb.) 

Steel, 

Structural 

(lb.) 

1913 
1917 
1918 
1919 
1920 

100. 0 
147.6 
207.2 

198.3 
180.8 

lOO.O 

203.9 

243-8 
274.2 
320.3 

lOO.O 

III. 7 
126.0 
156-3 
179-8 

100. 0 

387-5 
206.3 
168.8 
200.0 

'  See  references  on  the  construction  of  index  numbers  at  end  of  chapter. 


436  BANKING  AND  CREDIT  I XXXI 

In  this  form  the  series  of  prices  for  the  desired  commodities 
are  more  easily  compared.  A  further  step,  however,  can  be 
advantageously  taken;  the  four  series  may  be  averaged  to  show 
composite  prices  for  each  of  the  years: 

1913 lOO.O 

1917 212.7 

1918 195-8 

I9I9 1994 

1920 220.2 

ID.  Index  of  United  States  Bureau  of  Statistics. — In  the  fore- 
going tables,  only  four  articles  are  given,  and  each  is  considered 
of  equal  importance.  Composite  averages  which  are  computed 
from  such  restricted  data  are  likely  to  be  distorted  and  do  not 
express  representative  conditions.  It  is  therefore  desirable  to 
include  in  the  computation  a  large  number  of  commodities  and 
to  weight  them  according  to  their  relative  importance,  as  deter- 
mined by  the  amounts  consumed  or  marketed.  For  example,  the 
United  States  Bureau  of  Labor  Statistics  in  computing  index 
numbers  of  wholesale  prices  includes  over  300  articles  and 
weighs  the  price  of  each  article  by  the  estimated  cjuantity  of  the 
article  marketed  in  the  last  census  year.  Not  all,  however,  of  the 
index  numbers  in  current  use  present  the  comparisons  in  terms 
of  relative  numbers  calculated  in  percentages.  Bradstreet's 
index  number,  based  upon  about  100  articles,  represents  simply 
the  sum  of  actual  prices  reduced  to  a  per  pound  basis.  Some  of 
the  best  known  index  numbers  use  less  than  50  series  of  quotations; 
that  of  the  London  Economist  includes  44  articles,  that  of 
Sauerbeck  45,  and  the  New  York  Annalhst  series  25.  If  the 
articles  be  wisely  chosen,  there  is  little  variation  between  the  index 
number  based  upon  many  conmiodities  and  that  based  upon  a  few. 

The  table  on  the  following  page  shows  the  changes  in  whole- 
sale prices  between  1890  and  1920,  according  to  the  United 
States  Bureau  of  Labor  (1913   =   100):^ 


^  Monthly  Labor  Revieu\  Feb.  1921,  p.  45. 


XXXI 


MONETARY  PROBLEMS 


437 


United  States  Bureau  of  Labor  Index  Number  for  Wholesale 

Prices 


Year 

Index  Number 

Year 

Index  Number 

1890 

81 

1906 

88 

1891 

82 

1907 

94 

1892 

76 

1908 

91 

1893 

77 

1909 

97 

1894 

69 

1910 

99 

1895 

70 

1911 

95 

1896 

66 

1912 

lOI 

1897 

67 

1913 

100 

1898 

69 

1914 

100 

1899 

74 

1915 

lOI 

1900 

80 

1916 

124 

1901 

79 

1917 

176 

1902 

85 

1918 

196 

1903 

85 

1919 

212 

1904 

86 

1920 

243 

1905 

85 

The  bureau  al^o  publishes  index  numbers  for  retail  prices  of 
22  articles  of  food  for  the  years  1Q07-1920,  as  follows  (1913  = 
100)  :■' 


United  States  Bureau  of  Labor  Index  Numbers  for  Retail  Prices 


Year 

Index  Number 

Year 

Index  Number 

1907 

82 

1914 

102 

1908 

84 

1915 

lOI 

1909 

89 

1916 

114 

1910 

93 

1917 

146 

1911 

92 

1918 

167 

1912 

98 

1919 

186 

1913 

100 

1920 

203 

3  Monthly  Labor  Review,  Feb.  1921,  pp.  19-21. 


438  BANKING  AND  CREDIT  [  XXXI 

II.  Effects  of  Fall  in  Price  Levels. — Reference  has  been 
made  to  the  fall  of  prices  after  the  Civil  War,  continuing  until 
nearly  the  end  of  the  last  century,  and  to  the  influence  of  this 
decline  in  arousing  demand  for  inflation  in  the  currency,  either  by 
an  increase  in  government  paper  money  or  by  the  free  coinage  of 
silver.  Beginning  with  1897  there  was  an  upward  movement  in 
prices,  and  during  the  recent  war  the  advance  was  extreme.  As 
early  as  1910  the  advance  had  attracted  wide  public  discussion 
and  created  what  is  popularly  known  as  the  "cost  of  living'' 
problem.  More  recently,  beginning  with  1920,  there  has  been 
a  fall  in  prices.  The  effects  of  these  opposing  movements  may 
be  briefly  summarized  as  follows. 

A  fall  in  prices  is  especially  disadvantageous  to  producers 
who  have  borrowed  money  at  a  higher  level.  The  debt,  including 
principal  and  interest,  is  a  fixed  overhead  charge  which  must  be 
met,  though  the  selhng  price  of  goods  falls.  The  creditor  on  the 
other  hand  gains  by  a  fall  in  price,  and  in  the  organization  of 
economic  society  as  a  whole  it  may  be  said  that  the  loss  of  one 
class  is  offset  by  the  gain  of  the  other.  If,  however,  a  particular 
business  is  based  largely  upon  borrowed  capital,  so  that  interest 
forms  a  large  item  in  the  cost  of  production,  there  is  little  com- 
pensation, to  those  engaged  in  that  class  of  enterprise,  from  a 
fall  in  prices.  This  was  the  position  of  many  farmers  who  pur- 
chased farms  or  farm  equipment  upon  borrowed  money  at  the 
close  of  the  Civil  War,  and  as  a  result  many  of  this  class  supported 
the  earlier  proposals  for  inflation. 

A  similar  disadvantage  is  found  in  branches  of  business  which 
are  accustomed  to  carry  large  inventories  of  raw  materials  or 
finished  goods.  If  prices  fall,  sales  must  be  made  at  a  loss. 
Moreover,  in  a  falling  market  the  demand  for  goods  is  hesitating, 
for  each  possible  buyer  is  influenced  by  the  consideration  that  by 
waiting  he  may  be  able  to  purchase  the  goods  desired  at  a  lower 
price.  Falling  prices  thus  place  a  burden  upon  debtors,  may 
depress  business,  and  if  long  continued  may  cause  unemployment. 


XXXI]  MONETARY  PROBLEMS  439 

Wages  will  undoubtedly  be  reduced,  but  the  wage-earners  do  not 
necessarily  suffer  since  they  are  compensated  by  the  reduced 
cost  of  living.  Current  transactions  can  be  adjusted  to  a  new 
level  without  serious  disturbance,  but  the  settlement  of  contracts 
made  in  the  past  is  far  more  difficult. 

12.  Influence  of  Rising  Prices. — On  the  other  hand,  rising 
prices,  which  are  advantageous  to  the  producer,  are  a  burden  upon 
the  consumer.  If  the  consumer  is  at  the  same  time  a  producer  to 
an  equal  degree,  his  purchasing  power  is  not  changed,  but  if  the 
rise  be  rapid  it  is  difficult  to  make  these  adjustments  promptly, 
so  that  the  burden  of  an  increasing  cost  of  living  will  not  be  felt 
by  a  part  of  the  community.  The  rise  in  prices  places  greater 
burdens  upon  investors  and  those  who  receive  fixed  salaries. 
Investors,  however,  though  powerless  to  obtain  relief  until  their 
investments  mature,  and  though  they  must  make  sacrifices,  are 
not  as  a  class  endangered,  for  the  possession  of  an  investment 
gives  some  protection.  The  salaried  class  will  be  at  a  disadvan- 
tage, for  salaries  do  not  quickly  respond  to  changing  conditions 
of  economic  life,  but  this  group  generally  has  a  margin  of  com- 
pensation which  it  can  sacrifice  without  immediate  and  serious 
distress.  Wage-earners  are  more  frequently  in  a  position  to  secure 
a  readjustment  of  compensation  in  proportion  to  the  cost  of  liv- 
ing. The  rise  in  prices  stimulates  business  enterprise,  for  the 
manufacturer  is  protected  to  a  certain  degree  against  loss  by  the 
advance  in  the  price  of  the  raw  materials  which  enter  into  the 
finished  product,  during  the  time  which  it  takes  to  manufacture 
the  goods;  and  the  trader  is  likewise  safeguarded  because  to  the 
profit  obtained  by  marketing  is  added  the  differential  due  to  price 
increase.  During  the  period  of  rising  prices  there  is  a  greater 
disposition  to  assume  the  risk  of  indebtedness.  High  profits  not 
only  justify  an  expansion  of  business  upon  credit,  but  also  beget 
carelessness  in  incurring  debts.  As  long,  however,  as  prices  rise, 
danger  does  not  appear  imminent. 


440  BANKING  AND  CREDIT  [XXXI 

Many  reasons  have  been  given  for  the  rise  of  prices  beginning 
in  191 5,  and  various  plans  have  been  proposed  not  only  to  check 
the  rise  but  also  to  restore  the  pre-war  level.  Special  causes 
which  affect  prices,  as  changes  in  cost  of  production,  tarifT  duties 
and  taxation,  monopolies,  trade  union  regulations,  extravagance 
and  speculation,  lie  outside  of  our  subject  matter,  but  the  relation 
of  the  volume  of  money  to  prices  requires  a  brief  consideration  in 
order  to  explain  the  question  of  inflation  as  it  was  developed  dur- 
ing the  war  period. 

13.  Quantity  Theory  of  Money. — Economists  with  few  excep- 
tions agree  that  the  quantity  of  money  is  an  important  factor  in 
determining  the  general  level  of  prices.  This  is  known  as  the 
"  quantity  theory  of  money."  In  the  making  of  prices  two  factors 
are  included:  first,  the  volume  of  business  transactions,  and 
second,  the  supply  of  currency.  If  the  supply  of  money  and  other 
forms  of  credit  currency  increases  faster  than  the  quantity  of 
goods  transferred  in  the  market,  prices  will  rise;  if  the  quantity  of 
goods  to  be  marketed  increases  faster  than  the  circulating  me- 
dium, prices  will  fall;  and  if  both  increase  or  decrease  in  the  same 
proportion,  prices  will  remain  stationary. 

This  principle  may  be  illustrated  by  assuming  that  a  sudden 
addition  is  made  to  the  supply  of  money.  If  $100  million  worth 
of  gold  be  brought  from  the  mines  to  the  mints,  the  owners  of 
this  gold  will  be  in  possession  of  that  amount  of  coin  which  will 
be  spent  in  some  form  or  other.  A  part  will  be  expended  for 
commodities  and  this  will  create  an  additional  demand  for  these 
goods.  Their  price  will  tend  to  rise.  Or  if  the  mine-owners  invest 
a  part  in  securities,  as  of  railroads  or  manufacturing  corporations, 
the  money  will  be  used  by  these  companies  in  the  purchase  of 
supplies  and  equipment,  and  again  there  will  be  a  tendency  for 
such  goods  to  rise  in  price.  Labor  and  goods  engaged  in  the  proc- 
ess of  mining  have  been  converted  into  the  money  article,  which  is 
thereby  effective  for  continuous  exchange  and  valuation  of  articles. 


XXXII  MONETARY  PROBLEMS  441 

Or  suppose  that  there  are  100,000  workmen  whose  labor  can 
be  applied  either  to  agriculture  for  the  production  of  wheat  or  in 
mining  for  the  production  of  gold,  and  that  before  labor  begins 
operations  an  ounce  of  gold  is  worth  20  bushels  of  wheat.  If  gold 
is  $20  per  ounce, "^  the  price  of  wheat  is  $1  per  bushel.  Let  it  also 
be  assumed  that  labor  is  ec^ually  productive,  whether  in  agricul- 
ture or  in  mining;  that  is,  during  a  year  a  workman  can  produce, 
over  and  above  the  cost  of  production,  either  1,000  bushels  of 
wheat  or  50  ounces  of  gold.  If  mining  has  been  undertaken,  there 
is  an  immediate  market  for  the  gold  at  the  mint  at  a  fixed  price, 
viz.,  $20  per  ounce,  and  it  is  at  once  converted  into  coin  which  has 
a  purchasing  power  of  $100  million.  If  there  be  no  greater 
amount  of  wheat  on  hand  at  the  end  of  the  year,  and  there  is 
nothing  to  purchase  with  the  gold  except  wheat,  it  is  obvious  that 
the  added  purchasing  power  of  $100,000,000  would  greatly  in- 
crease the  demand  for  wheat.  An  owner  of  gold  would  give 
more  than  a  twentieth  of  an  ounce,  or  $1  of  gold,  for  a  bushel  of 
wheat.    The  price  of  wheat  would  rise. 

On  the  other  hand,  if  the  labor  had  been  directed  to  the  grow- 
ing of  wheat,  100  million  bushels  would  be  offered  for  sale.  If 
there  be  no  greater  amount  of  gold  at  the  end  of  the  year  than 
there  was  at  the  beginning,  and  there  was  nothing  to  exchange 
for  the  wheat  except  gold,  it  is  obvious  that  the  added  offering 
of  100  million  bushels  of  wheat  would  greatly  increase  the  de- 
mand for  gold.  An  owner  of  a  bushel  of  wheat  would  give  more 
than  a  bushel  for  a  twentieth  of  an  ounce  of  gold,  or  $1 .  That  is, 
the  price  of  a  bushel  would  be  less  than  $1,  or  price  falls. 

If  50,000  workmen  are  engaged  in  raising  wheat  and  50,000 
in  mining  gold,  the  result  would  be  50  million  bushels  of  wheat 
and  25,000  ounces  of  gold.  The  purchasing  power  of  the  gold  is 
$50  million  and  the  ratio  of  wheat  to  gold  is  exactly  the  same  as 
at  the  beginning  of  the  year. 


••  $20,  rather  than  the  actual  mint  price  of  gold,  is  assumed  for  convenience  in  calcula- 
tion. 


442  BANKING  AND  CREDIT  [XXXI 

In  the  foregoing  illustration  it  has  been  assumed  that  there 
are  only  two  commodities,  wheat  and  gold.  The  same  forces  are 
operative  if  there  be  more  than  two  commodities.  Assume  that 
50,000  workmen  mine  gold,  25,000  raise  wheat,  and  25,000  manu- 
facture woolen  cloth;  also  that  before  this  new  production,  a 
bushel  of  wheat  will  exchange  for  a  yard  of  cloth.  Prices,  there- 
fore, are:  wheat,  $1  per  bushel;  cloth,  $1  per  yard. 

At  the  end  of  the  year  there  is  a  new  supply  of  gold  convert- 
ible into  coin,  $50  million.  There  is  also  an  addition  of  25  million 
bushels  of  wheat  and  25  million  yards  of  cloth.  There  is  no 
change  in  the  ratio  between  wheat  and  cloth,  but  there  is  a  change 
in  the  ratio  between  gold  and  wheat,  and  equally  so  between  gold 
and  cloth.  The  possessors  of  gold  may  prefer  to  increase  their 
holdings  of  cloth  rather  than  of  wheat.  Purchasing  power  will  be 
directed  toward  cloth  more  than  toward  wheat.  The  price  of 
cloth  will  rise  accordingly,  and  if  purchasing  power  is  not  applied 
to  wheat,  the  price  of  that  commodity  may  not  be  affected.  But 
it  is  probable  that  the  possessors  of  cloth  may  desire  a  greater 
amount  of  wheat.  With  the  gold  obtained  in  exchange  for 
cloth,  they  will  apply  their  purchasing  power  upon  wheat,  and 
the  price  of  wheat  rises.  The  mere  presence  of  gold  does  not 
change  prices,  but  the  use  of  gold  is  its  influence  upon  purchasing 
power. 

14.  Credit  Money  and  the  Quantity  Theory. — A  similar 
effect  is  brought  about  if  forms  of  credit  money,  as,  for  example, 
bank  notes  or  deposit  credits,  are  created.  As  money  and  credit 
instruments  are  identical  in  their  power  to  effect  exchanges,  their 
use  afl'ects  prices  in  an  equal  degree.  Taussig  states  this  position 
as  follows: 

A  purchase  on  credit  has  the  same  immediate  effect  in  prices 
as  a  purchase  with  cash.  If,  in  addition  to  a  given  number  of  pur- 
chasers offering  money,  there  are  as  many  more,  whose  credit  is 
good,  offering  to  buy  on  time,  the  effect  on  the  seller  is  the  same 


XXXI  ]  MONETARY  PROBLEMS  443 

as  if  the  entire  number  offered  money.     With  a  fixed  supply  of 
commodities,  prices  would  double  in  either  case.  ^ 

The  credit  of  banks  or  of  business  enterprise  is  transformed 
into  a  medium  by  which  purchasing  power  is  expressed. 

The  increase  in  spending  power  is  illustrated  by  the  loans  of 
national  banks.  In  1914  (June  30)  these  amounted  to  $6,430 
million;  in  1918  (November  i)  they  were  $10,007  million;  and  in 
1920  (May  4),  $12,289  million.  In  six  years  the  bunks  were  able 
to  grant  to  borrowers  facilities  by  which  they  could  nearly  double 
their  purchasing  power.  This  would  constitute  an  important 
factor  in  increasing  the  demand  for  commodities  and  tend  to  raise 
prices.  These  loans  were  not  necessarily  made  in  actual  money, 
but  could  be  effected  by  deposit  credits. 

If  these  new  loans  and  deposit  currency  represented  a  corre- 
sponding increase  in  business  transactions  and  consequently  an 
increase  in  the  amount  of  money  work  to  be  done,  there  would  be 
no  change  in  prices.  If,  however,  they  represented  new  acces- 
sions of  money,  as  gold  and  bank  notes,  with  a  proportionately 
less  amount  of  business  transactions  to  be  handled,  the  relation 
between  the  money  supply  and  commodities  would  be  changed 
and  prices  would  rise.  This  was  the  case.  Large  imports  of  gold 
meant  a  decrease  of  commodities  in  return  for  an  increase  of  gold; 
large  issues  of  federal  reserve  notes  in  exchange  for  government 
obligations  meant  a  consumption  and  destruction  of  commodities 
in  return  for  ultimate  promises  of  the  government.  The  govern- 
ment through  the  machinery  of  bond  issues  and  the  federal  re- 
serve banks  was  a  generous  spender;  its  increased  purchasing 
tended  to  raise  prices;  and  this  in  turn  enabled  individuals  who 
produced  to  increase  their  purchasing  power.  But  there  was  not 
a  corresponding  increase  in  production  or  amount  of  commodities 
to  be  sold.  Purchasing  power  outstripped  the  volume  of  business 
transactions  to  be  handled. 


5  p.  W.  Taussig,  Principles  of  Economics,  Vol.  I,  p.  427, 


444  BANKING  AND  CREDIT  [  XXXI 

In  the  application  of  the  quantity  theory  of  money,  money  is 
given  a  broad  interpretation — it  includes  not  only  gold  and  silver 
coins,  government  promissory  notes,  and  bank  notes,  but  also 
deposit  currency — it  comprehends  everything  which  performs  the 
work  of  money.  Consideration  must  also  be  given  to  the  velocity 
of  circulation — that  is,  the  rapidity  with  which  exchanges  can  be 
effected — and  also  to  the  volume  of  trade  which  gives  rise  to 
exchange  transactions.    As  Walker  states  it: 

Wc  should  all  agree  that  the  value  of  money  depended  on  the 
demand  for  and  supply  of  money.  In  speaking  of  the  demand  for 
money,  we  should  of  course  understand  that  the  effective  occa- 
sions for  its  use  in  exchange  were  meant,  and  consequently,  we 
should  have  reference  not  merely  to  the  amount  of  goods  pur- 
chased, but  also  to  the  frequency  with  which  those  goods  were  to 
be  exchanged  in  their  passage  from  producer  to  consumer.  Again, 
in  speaking  of  the  supply  of  money,  it  would  be  understood,  almost 
without  the  necessity  of  explanation,  that  reference  was  had,  not 
alone  to  the  number  of  money  pieces,  but  also,  and  conjointly 
with  this,  to  the  rapidity  of  their  circulation.  "The  nimble  six- 
pence does  the  work  of  the  slow  shilling."^ 

It  must  not  therefore  be  assumed  that  it  is  an  easy  matter 
to  determine  what  prices  will  be,  simply  from  a  consideration  of 
the  volume  of  money.  There  is  a  continuous  change  in  the 
volume  of  trade,  in  the  velocity  of  circulation  of  money  and 
credit,  in  the  ratio  between  bank  reserves  and  deposits,  and  in 
the  volume  of  deposits.  All  that  can  be  claimed,  at  the  present 
stage  of  analysis  of  market  and  trade  operations,  is  that  over  a 
long  period  of  time  the  quantity  of  money  determines  the  level 
of  prices.  During  shorter  periods  there  are  many  factors,  whose 
influences  are  not  as  yet  clearly  understood,  which  enter  into 
the  determination  of  current  prices.  Particularly  is  this  true  of 
transition  periods  so  characteristic  of  the  business  cycle  today. 


*  "The  Value  of  Money,"  paper  read  before  American  Economic  Association  (1893), 
published  in  Discussions  in  Economics  and  Statistics,  Vol.  I,  p.  196. 


XXXI]  MONETARY  PROBLEMS  445 

Professor  Irving  Fisher,  one  of  the  most  recent  and  vigorous  ad- 
vocates of  the  quantity  theory,  makes  the  following  qualifications: 

We  have  seen,  for  instance,  that  a  sudden  change  in  the  quan- 
tity of  money  and  deposits  will  temporarily  afifect  their  velocities 
of  circulation  and  the  volume  of  trade.  Reversely,  seasonal 
changes  in  the  volume  of  trade  will  affect  the  velocities  of  cir- 
culation, and  even,  if  the  currency  system  is  elastic,  the  quantity 
of  money  and  deposits.  In  brisk  seasons,  as  when  "money  is 
needed  to  move  the  crops,"  the  velocity  of  circulation  is  evi- 
dently greater  than  in  dull  seasons.  Money  is  kept  idle  at  one 
time  to  be  used  at  another,  and  such  seasonal  variations  in  veloc- 
ity reduce  materially  the  variations  which  otherwise  would  be 
necessary  in  the  price  level.  In  a  similar  way  seasonal  varia- 
tions in  the  price  level  are  reduced  by  the  alternate  expansion 
and  contraction  of  an  elastic  bank  currency.  In  this  case  tem- 
porarily, and  to  an  extent  limited  by  the  amount  of  legal  tender 
currency,  money  or  deposits  or  both  may  be  said  to  adapt  them- 
selves to  the  amount  of  trade.  In  these  two  ways,  then,  both 
the  rise  and  fall  of  prices  are  mitigated.  Therefore  the  "quan- 
tity theory"  will  not  hold  true  strictly  and  absolutely  during 
transition  periods. '^ 

15.  Relation  of  Prices  and  Volume  of  Currency  Illustrated. — 

During  the  recent  rapid  rise  of  prices,  there  was  a  great  increase 
in  the  volume  of  currency.  Is  there  any  causal  relation  between 
the  two  movements?  The  question  may  be  illustrated  by  an 
analysis  which  Professor  E.  W.  Kemmerer  has  made,  represent- 
ing the  growth  of  business  (as  indicated  by  12  indices,  e.  g., 
production  of  pig  iron,  wheat,  cotton,  coal,  freight  tonnage, 
building,  etc.),  monetary  circulation, '  deposit  currency,  and 
prices.  ^ 

Using  index  numbers  in  order  to  compare  different  economic 
movements,  the  changes  which  took  place  between  19 10  and  191 7 
are  presented  as  follows  (the  average  of  1910-1914  =  100): 


'  The  Purchasing  Power  of  Money,  p.  i6r. 

*  "Inflation,"  in  American  Economic  Review,  Vol.  VIII  CJune  191S 


446  BANKING  AND  CREDIT  [XXXI 

Table  Showing  Changes  in  Several  Economic  Factors,  1910-1917 


Year 

Growth  of 

Monetary 

Bank 

Wliolesale 

Business 

Circulation 

Deposits 

Prices 

1910 

93 

95 

90 

99 

1911 

95 

98 

94 

97 

1912 

102 

100 

102 

lOI 

1913 

105 

102 

104 

102 

1914 

104 

106 

no 

lOI 

1915 

108 

III 

118 

102 

1916 

113 

125 

147 

125 

1917 

127 

148 

174 

178 

From  this  tabic  it  can  be  computed  that  growth  of  business 
increased  between  1913  and  191 7,  21  per  cent;  monetary  circula- 
tion 45  per  cent;  bank  deposits  67  per  cent;  and  prices  75  per 
cent.  During  the  next  two  years,  1918-1919,  the  physical  volume 
of  trade  declined,  while  there  was  a  further  increase  in  monetary 
circulation,  bank  deposits,  and  prices.  If  the  volume  of  trade 
declined,  it  may  be  assumed  that  the  volume  of  exchange  trans- 
actions requiring  the  use  of  money  declined.  The  need  of  money 
to  do  money  work  accordingly  diminished.  If  at  the  same  time 
the  volume  of  money  and  bank  credit  increased  and  prices  of  practi- 
cally all  commodities  were  higher,  it  is  concluded  that  the  cause 
was  an  increased  supply  of  money  rather  than  a  scarcity  of  goods. 

16.  Equation  of  Exchange. — The  operation  of  the  quantity 
theory  of  money  may  be  expressed  by  an  algebraic  formula. 
Professor  Kemmerer  states  it  as  follows:^ 
MR 

^  =if 

P  =  price. 

M  =  money. 

R  =  rapidity  of  circulation. 

N  =  the  amount  of  business  or  number  of  business  transactions. 


'  E.  W.  Kemmerer,  Money  and  Prices,  p.  15. 


XXXI]  MONETARY  PROBLEMS  447 

Professor  Irving  Fisher  presents  the  equation  of  exchange  in 
somewhat  fuller  form  : 

MV  +  M'V  =  PT 

M    represents  the  volume  of  money  in  circulation,  exclusive  of 
the  amount  in  the  United  States  Treasury  and  banks. 

V  represents  the  velocity  of  its  circulation,  that  is,  the  number 

of  times  that  the  money  in  circulation  is  turned  over  in  a 
year. 
M    represents  the  volume  of  bank  deposits  subject  to  check. 

V  represents  the  velocity  of  circulation  of  M',  that   is,  the 

activity  of  bank  accounts. 
T     represents  the  volume  of  trade,  or  the  transactions  effected  by 

money  and  deposits. 
P     represents  the  price  level. 

In  the  above  equation,  therefore,  MV,  representing  the  prod- 
uct of  the  money  in  circulation  multiplied  by  its  velocity  of 
circulation,  expresses  the  total  monetary  circulation  or  the  total 
expenditure  of  money  per  annum. 

In  the  same  way  M'V  expresses  the  total  deposit  circulation, 
or  the  total  expenditure  by  checks  per  annum. 

PT  represents  the  total  value  of  the  goods  bought,  expressed 
as  the  product  found  by  multiplying  the  price  level  by  the  volume 
of  trade. 

From  this  equation,  it  is  obvious  that: 

MF  +  M'V' 
T 

As  V  (velocity  of  money  in  circulation)  is  fairly  constant,  this 
means  that  the  price  level  moves  up  or  down  according  to  the 
increase  or  decrease  in  money,  to  the  change  in  deposits  subject 
to  check,  and  to  the  varying  velocity  of  the  deposit  checks.  The 
change  in  M'V  is  reflected  in  the  fluctuations  in  bank  clearings. 
The  foregoing  equations  of  Kemmerer  and  Fisher  are  in  no 
sense  a  proof  of  the  quantity  theory  of  money.    They  are  simply 


448  BANKING  AND  CREDIT  [  XXXI 

expressions  of  an  identity.  The  equivalence  of  the  two  sides  of 
an  equation  over  a  period  of  years  neither  demonstrates  nor  dis- 
proves the  quantity  theory. 

Statistical  calculations  have  been  made  by  Professor  Fisher 
for  the  five  factors,  M,  M',  V,  V ,  and  T  for  a  series  of  years 
beginning  with  1896,  and  the  resultant  values  of  P  determined. 
A  comparison  of  these  values  with  the  actual  level  of  prices  as 
determined  by  index  numbers  shows  but  slight  differences. 

17.  Multiple  or  Tabular  Standard  of  Value. — Various  pro- 
posals have  been  made  to  remedy  the  disturbances  caused  by 
fluctuations  in  the  price  level.  One  of  the  earliest  of  these  plans 
was  the  multiple  or  tabular  standard  of  value,  based  upon  the 
prices  of  commodities.  By  the  use  of  such  a  standard  a  debtor 
would  pay  in  money,  not  the  sum  which  he  originally  borrowed, 
but  a  sum  which  would  buy  the  same  amount  of  goods  as  could 
have  been  purchased  at  the  time  the  debt  was  contracted.  The 
determination  of  these  amounts  would  be  effected  through  the 
preparation  and  publication  of  index  numbers  by  some  con- 
stituted authority,  as  the  government;  and  the  changes  in  index 
numbers  would  measure  the  money  equivalent  to  be  paid. 

Reference  has  been  made  to  the  fall  of  prices  after  the  Civil 
War.  Let  it  be  assumed  that  the  index  number  of  articles  selected 
for  the  multiple  standard  was  120  in  1870  and  that  a  debt  of 
$1,000  was  incurred  in  that  year,  running  for  five  years  at  6  per 
cent  interest.  At  the  end  of  one  year,  when  interest  is  due,  the 
index  number  stands  at  1 14.  How  much  should  the  debtor  pay 
and  how  much  should  the  creditor  receive,  in  order  to  remain  on 
exactly  the  same  economic  footing  as  when  the  loan  was  made? 
The  prices  of  commodities  have  fallen  5  per  cent;  obviously  $57 
will  purchase  as  much  as  the  $60  anticipated.  The  creditor  is 
receiving  a  compensation,  measured  in  purchasing  power,  which 
will  give  him  the  same  purchasing  power  as  he  enjoyed  when  he 
made  the  loan. 


XXXI]  MONETARY  PROBLEMS  449 

If  the  index  number  should  rise  to  126,  economic  equity,  by 
the  same  reasoning,  would  demand  that  the  debtor  pay  $63  in 
order  that  the  creditor  should  not  suffer  any  real  loss  in  the  in- 
come which  he  expected. 

In  the  table  on  page  43  7  it  is  seen  that  prices  rose  between  1 896 
and  1913,  a  period  of  17  years,  from  67  to  100.  If  an  investor 
purchased  in  the  former  year  at  par  a  4  per  cent  $1,000  bond, 
maturing  in  1913,  he  would  receive  annually  $40,  and  at  maturity 
$1,000.  As  prices  rose,  the  $40  which  the  investor  received  year 
by  year  would  purchase  a  diminishing  amount  of  articles,  and 
in  1 913,  the  $1,000  received  on  payment  of  the  principal  of  the 
loan  would  purchase  far  less  than  in  1896.  Not  only  did  the  in- 
terest payments  yield  less  real  income  than  had  been  anticipated, 
but  the  purchasing  power  of  the  principal  when  returned,  was  less 
by  one-third. 

As  yet  proposals  for  the  substitution  of  a  standard  other 
than  gold  have  attracted  but  little  interest.  Index  numbers  are 
only  approximations  of  the  actual  level  of  prices  and  their  proper 
construction  is  still  a  matter  of  dispute,  owing  to  technical 
difficulties  in  the  selection  of  the  articles,  the  variation  of  prices 
of  the  same  article  in  different  markets,  and  the  uncertainty  of 
the  degree  of  weight  to  be  given  to  the  several  commodities. 
Notwithstanding  their  defects,  which  make  the  compulsory 
acceptance  of  such  a  standard  undesirable,  the  principle  of  a 
multiple  standard  has  been  used,  apparently  with  advantage,  by 
voluntary  agreement.  For  example,  certain  employers  pay  their 
workmen  wages  which  are  periodically  adjusted  to  prices  as 
indicated  by  one  of  the  current  series  of  index  numbers. 

18.  Stabilized  Dollar. — The  use  of  a  multiple  standard  does 
not  do  away  with  price  fluctuations;  it  is  simply  a  device  to 
mitigate  the  evils.  In  more  recent  years,  attention  has  been 
directed  to  the  possibility  of  preventing  price  fluctuations  by 
changes  in  the  money  standard.    For  example,  Professor  Fisher 


450  BANKING  AND  CREDIT  [XXXI 

proposes  that  the  weight  of  the  gold  dollar  be  varied  so  as  to  keep 
its  purchasing  power  unvariable. ' "  "We  now  have  a  gold  dollar 
of  constant  weight  and  varying  purchasing  power.  We  need  a 
dollar  of  constant  purchasing  power  and  therefore  of  varying 
weight."  Professor  Fisher  would  not  abandon  the  gold  standard, 
but  simply  change  the  weight  of  the  gold  dollar  as  prices  rose  or 
fell.  Gold  coins  would  be  abolished  and  the  government  would 
hold  all  the  physical  gold,  against  which  bulhon  certificates  are  to 
be  issued.  Thus  an  ounce  of  gold  held  by  the  government  would 
support  a  varying  number  of  dollar  bullion  certificates,  according 
as  prices  changed.  The  degree  of  change  in  the  weight  of  the  gold 
dollar  supporting  the  bulhon  certificate  would  be  adjusted  to 
the  change  of  prices  as  determined  by  the  index  number  of  prices. 
If  prices  rise  i  per  cent,  i  per  cent  more  gold  will  be  added  to 
the  dollar.  As  all  gold  circulated  in  the  form  of  paper  representa- 
tives, it  would  be  possible  to  vary  at  will  the  weight  of  the  gold 
dollar  "without  any  annoyance  or  complexity  as  would  arise 
from  the  existence  of  coins."  The  result  would  be  a  stabilized 
dollar. 

The  plan  has  the  merit  of  simplicity,  but,  like  the  use  of  a 
multiple  standard,  involves  a  radical  change  in  the  habits  of  the 
business  world.  It  is  not  likely,  therefore,  that  it  will  receive  any 
large  degree  of  support  in  the  near  future.  It  is  desirable,  however, 
that  the  unsatisfactory  service  of  the  present  monetary  standard 
be  clearly  recognized  and  that  sympathetic ,  consideration  be 
given  to  all  proposals  that  might  diminish  violent  changes  in 
the  purchasing  power  of  money. 

References 

'  The  Quantity  Theory  of  Money 

Carver,  T.  N.    Principles  of  National  Economy,    pp.  385-388. 
Clay,  H.     Economics  for  the  General  Reader,     pp.  198-203. 


'"  This  plan  is  fully  described,  and  objections  considered,  in  Irving  Fisher,  Stabiliz- 
ing the  Dollar  (1919).  The  author  cites  writings  of  others  who  have  proposed  similar 
plans. 


XXXI  1  MONETARY  PROBLEMS  451 

Fetter,  F.  A.     Modern  Economic  Problems,     pp.  30-35. 
Gide,  C.     Political  Economy,    pp.  232-237. 
Laughlin,  J.  L.     Principles  of  Money. 

Presents  a  detailed  discussion  of  the  theories  of  different  writers. 
His  position  is  adverse  to  the  theory,  pp.  225-334. 
Taussig,  F.  W.    Principles  of  Economics.    Vol.  I. 

The  theory  is  accepted  if  "  rightly  stated,"  pp.  236-242. 
Westerfield,  R.  B.     Banking  Principles  and  Practice.  Vol.  I,  pp.  162-172. 

Proceedings  of  the  Meeting  of  the  American  Economic  Associa- 
tion, held  at  St.  Louis,  Dec.  iqio,  published  as  supplement  of  the 
American  Economic  Review,  Apr.  191 1,  pp.  37-70,  contains  a  paper 
by  Professor  Fisher,  and  criticism  by  other  speakers.  Much  of  this 
is  reprinted  in  Phillips,  C.  A.,  Readings  in  Money  and  Banking, 
pp. 159-210. 

hidex  Numbers 

Mitchell,    W.  C.      Index  Numbers  of  Wholesale  Prices  in  the   United 

States  and  Foreign  Countries. 
Secrist,  H.     Introduction  to  Statistical  Methods,  pp.  294-396. 
Johnson,  J.  F.     Money  and  Currency,  pp.  103-112. 
Taussig,  F.  W.     Principles  of  Economics.     Vol.  I,  pp.  290-296. 

Equation  of  Exchange 

Fisher,  I.     Purchasing  Power  of  Money. 

Especially  Chapter  12,  pp.  276-318,  where  the  author  makes  a 
full  statement  of  his  method  and  presents  the  results  of  his  statis- 
tical calculations.  Generous  recognition  is  given  to  the  work  of 
Professor  E.  W.  Kemmerer,  Money  and  Credit  Instruments  in 
Their  Relations  to  General  Prices  (1909).  Professor  Fisher's 
analyses  are  also  presented  in  the  American  Economic  Review,  Vol. 
I  (1911),  pp.  296-305;  Vol.  II  (1912),  pp.  302-319;  Vol.  Ill,  pp.  196- 
198;  Vol.  IV,  p.  465;  Vol.  V,  pp.  407-413;  Vol.  VI,  p.  457;  Vol.  VII, 
pp.  934-938;  Vol.  VIII,  p.  871;  Vol.  IX,  pp.  407-409;  these  continue 
the  calculations  of  the  equation  through  the  year  1918. 


APPENDIX  A 
PROBLEMS  WITH  SOLUTIONS 

In  banking  and  credit,  as  in  other  branches  of  economics,  a 
liberal  use  of  illustrative  problems  serves  to  promote  effectively 
a  thorough  grasp  of  the  subject.  Not  only  is  the  student  given 
a  nucleus  about  which  he  can  center  his  ideas  gained  in  dealing 
with  material  of  a  more  abstract  nature,  but  he  has  the  important 
satisfaction  of  knowing  that  he  has  accomplished  some  concrete 
and  tangible  part  of  his  task.  From  the  viewpoint  of  the  teacher 
a  well-selected  problem  should  serve  as  a  talking  point  or  a  text, 
from  which  he  can  expand  and  digress  as  much  as  he  judges  it 
to  be  desirable.  Naturally  many  points  are  not  susceptible  of  one 
definite  answer  but  are  more  or  less  moot ;  not  to  bring  this  to 
the  realization  of  the  student  is,  of  course,  quite  as  bad  as  to  leave 
him  with  merely  very  general  impressions. 

Solutions  have  been  furnished  with  some  of  these  problems  for 
two  chief  reasons;  first,  in  order  that  they  may  serve  as  a  guide  in 
working  out  similar  problems  set  by  the  instructor  and,  second, 
to  save  time  for  the  reader  or  student  who  can  master  the  point 
of  the  problem  without  obtaining  an  independent  answer.  For 
the  purpose  of  providing  the  student  with  similar  problems  for 
independent  solution,  the  instructor  may  easily  vary  the  figures  in 
the  problems  presented  here  in  the  Appendix  as  well  as  those 
scattered  throughout  the  main  part  of  the  text. 

To  aid  the  reader  in  solving  the  problems,  interest  tables  will 
be  found  in  Appendix  C. 

I.  A  mining  company  sends  to  the  United  States  Mint  10,000  ounces  of 
gold,  .950  fine.  The  mint  charges  2  cents  an  ounce  for  removing  the  im- 
purities. The  gold  is  coined  into  pieces  of  standard  fineness.  How  much 
gold  will  the  company  receive  in  dollars,  there  being  no  charge  for  coining 

453 


454  APPENDIX 

except  2^2  cents  per  ounce  for  the  copper  alloy?  The  coining  value  of  an 
ounce  of  pure  gold  is  $20.67183.  United  States  gold  coins  are  9/10  fine 
and  i/io  alloy. 

Solution  i  (basis  value) : 
10,000  ounces  .950  fine  =  9,500  ounces  pure  gold 
9,500  ounces  pure  gold  X  $20.67183  =  $196,382.39,  value  in  coin 
9,500 -j-  9  =  1,055.55  ounces  of  alloy 
1. 055-55  X  $.02  1/2  =  $26.39,  charge  for  alloy 
10,000  X  $.02  =  $200,  charge  for  refining 
$200  +  $26.39  =  $226.39,  total  charges 
$196,382.39  —  $226.39  =  $196,156.00,  net  coin  received 

Solution  2  (basis  weight): 

I  ounce  troy  weight  =  480  grains 

Fine  gold  in  $1  =  23.22  grains 

9,500  X  480       ^  *     .     „ 

^—  X  $1   =  $196,382.43 

23.22 

$196,382.43  —  $226.39  charges  as  above  =  $196,156.04,  net  coin 

received. 

Difference  of  $0.04  in  answer  is  due  to  use  of  decimal  fraction  in 
Solution  I. 

2,  Suppose  that  the  weight  of  the  gold  dollar  is  increased  i  percent. 
What  will  be  the  mint  price  of  gold  per  fine  ounce? 

Solution: 

Grains  of  fine  gold  in  dollar  at  present 23.22 

Add  I  % 0.2322 

Grains  if  weight  is  increased  I  % 23.4522 

Divide  480,  the  number  of  grains  in  an  ounce  of  gold,  by  23.4522 
(times  $1)  and  the  result,  $20.47,  will  be  the  mint  price  under  the 
conditions  given. 

3.  Suppose  that  the  weight  of  the  gold  dollar  is  increased  i  per  cent. 
What  will  be  the  par  of  exchange  with  England? 

Solution: 

Grains  of  fine  gold  in  dollar  if  weight  is  increased  i  % .  .  .        23.4522 
Grains  of  fine  gold  in  a  sovereign 1 13.0016 

Dividing  1 13.0016  by  23.4522  (times  $1),  the  result,  $4,818,  is  the  par 
of  exchange  with  England  under  the  conditions  given. 


PROBLEMS  WITH  SOLUTIONS  455 

4.  Suppose  that  the  gold  dollar  is  1 1/12  fine,  with  no  change  in  weight. 
What  will  be  the  mint  price  of  gold  per  fine  ounce? 

Solution: 

Present  weight  of  gold  dollar,  25.8  grains 
11/12  X  25.8  =  23.65  grains  of  fine  gold 

Divide  480,  the  number  of  grains  in  an  ounce  of  gold,  by  23.65  (times 
$1)  and  the  result,  $20.30,  will  be  the  mint  price  per  fine  ounce  under 
the  conditions  given. 

5.  Suppose  that  the  gold  dollar  is  i  i/i  2  fine  with  no  change  in  weight. 
What  will  be  the  par  of  exchange  with  England? 

Solution: 

Grains  of  fine  gold  in  dollar  if  1 1/12  fine 23.65 

Grains  of  fine  gold  in  a  sovereign 1 13.0016 

Dividing  1 13.0016  by  23.65  (times  $1),  the  result,  $4-778,  would  be  the 
par  of  exchange  with  England  under  the  conditions  given. 

6.  If  a  $20  gold  piece  is  melted  what  will  the  gold  bullion  be  worth? 
If  $20  in  silver  dollars  is  melted  what  will  the  silver  bullion  be  worth? 
Explain  the  reason  for  the  difference.  Assume  that  the  gold  and  silver 
coins  are  full  weight  and  have  not  been  worn  by  circulation. 

Solution: 
(a) 

Grains  of  pure  gold  in  a  dollar,  23.22,  and  in  $20,  464.40 

464.40 
464.40  grains  = ounces 

464.40  ^  ■  ■  n  * 

X  $20.67,  mint  price  per  tine  ounce  =  $20 

480 

(The  calculation  does  not  work  out  exactly  $20,  which  is  the  correct 
answer,  as  the  mint  price,  $20.67,  is  not  an  exact  figure  but  the  price  to 
the  nearest  cent.) 

(b)  Weight  of  a  standard  silver  dollar  is  412.5  grains  9/10  fine;  $20  in 
silver  therefore  contains  8,250  grains  9/10  fine.  The  price  of  silver  like  any 
other  commodity  is  continually  changing.    At  60  cents  per  standard  ounce, 

8,250  grains  is  worth  ^-^  X  $0.60  =  $10.3125,  or  each  silver  dollar  will 
480 

have  an  intrinsic  value  of  $0.515625. 


456  APPENDIX 

(c)  Gold  is  the  monetary  standard  of  the  United  States  and  has  a  free 
and  unlimited  coinage.  Anyone  may  send  gold  bullion  to  the  mint  and 
after  paying  slight  charges  for  assaying  and  refining,  etc.,  will  receive 
coins  equal  in  weight  to  the  metal  sent.  Gold  bullion  of  a  given  weight 
and  fineness,  therefore,  will  command  in  the  market  a  price  equal  to  the 
number  of  gold  dollars  it  will  make  if  coined.  The  possibility  of  melting 
the  coin  into  bullion  or  having  the  bullion  coined  causes  an  interchange- 
ability  and  consequently  an  identical  value  for  a  given  quantity  of  gold 
in  the  form  of  bullion  or  coin. 

It  is  assumed,  of  course,  in  the  above  statements  that  we  are  consider- 
ing the  normal  situation  when  the  country  is  actually  on  a  gold  standard 
and  has  not  temporarily  suspended  specie  payments,  as  in  the  case  of 
most  European  countries  at  present. 

Silver  does  not  have  free  and  unlimited  coinage  like  gold;  no  individual 
may  send  silver  bullion  to  the  mint  for  coinage.  From  time  to  time  silver 
is  purchased  in  the  market  by  the  government  in  competition  with  other 
buyers  who  desire  it  for  industrial  and  other  commercial  purposes. 

In  iQiQ  silver  bullion  reached  an  exceptionally  high  price  and  this  was 
reflected  in  high  exchange  rates  on  silver  standard  countries.  In  order  to 
stabilize  such  exchanges  and  more  particularly  those  on  the  Far  East, 
the  Treasury  released  for  foreign  shipment  some  of  the  silver  dollars  it 
then  held.  At  the  same  time  Congress  passed  a  law  which  provided  for  the 
subsequent  purchase  of  an  equivalent  amount  of  silver  bullion  at  $i  an 
ounce  co  replace  these  silver  dollars  which  had  been  released  by  the 
Treasury.  Aside  from  this  artificial  price ,  which  will  disappear  when  the 
total  quantity  of  bullion  provided  for  is  purchased,  the  price  of  silver  is 
determined  in  the  same  way  as  the  price  of  any  other  commodity. 

Only  by  limiting  the  number  of  silver  coins  to  the  needs  of  the  country 
can  their  value  be  kept  equal  to  the  value  of  gold  coins.  Obviously ,  when- 
ever the  government  purchases  50  cents'  worth  of  silver  and  coins  4  quar- 
ters or  10  dimes  it  is  making  a  profit  of  50  cents.  This  source  of  profit, 
however,  has  decided  limitations.  Any  attempt  to  carry  it  beyond  the 
needs  of  the  country  would  endanger  our  gold  standard  and  bring  about 
confusion  in  our  monetary  system. 

7.  A  business  house  negotiates  a  loan  at  its  bank  by  discounting  a  60- 
day  non-interest-bearing  note  for  $10,000  received  from  a  customer.  The 
note  is  discounted  at  7  per  cent  on  the  day  it  is  received  and  the  borrower 
agrees  to  maintain  a  deposit  balance  of  about  20  per  cent  of  the  loan,  or, 

say,  $2,000. 


PROBLEMS  WITH  SOLUTIONS  457 

(a)  What  is  the  real  rate  of  interest  paid  by  the  borrower,  assuming 
that  the  bank  pays  no  interest  on  deposit  balances? 

(b)  Answer  the  same  question  assuming  that  the  bank  pays  2  per  cent 
interest  on  the  deposit  balance  which  averages  $2,000. 

Solution: 

(a) 

Face  of  60-day  note $10,000.00 

Deduct  interest  at  7^0  for  60  days 1 16.67 

Proceeds  to  credit  of  borrower $9,883.33 

Deduct  balance  not  withdrawn 2,000.00 

Amount  of  loan  actually  used $71883.33 

$116.67 

=  .0148,  rate  of  interest  for  60  davs 

$7,883.33 

.0148  X  6  =  .0888,  rate  of  interest  for  i  year  of  360  days 

(b) 

7%  discount  on  $10,000  for  60  days $116.67 

Deduct  2%  interest  on  $2,000  for  2  months 6.67 

Net  cost  of  funds  l^orrowed $1 10.00 

Amount  of  loan  actually  used $71883.33 

$110.00 

=  .014,  rate  of  interest  for  60  days 

$7,883.33 

.014  X  6    =  .084,  rate  for  i  year  of  360  days 

8.  On  April  i  a  merchant  presents  for  discount  at  a  bank  a  note  dated 
the  same  day  for  $5,000  due  in  60  days.  The  note  bears  interest  at  6  per 
cent  and  the  bank's  rate  of  discount  is  6  per  cent.  What  will  the  note  yield 
to  the  merchant? 

On  ]\Iay  i  the  bank  sells  the  above  note  to  another  bank  at  the  same 
discount  rate.  What  profit  will  the  first  bank  make  by  the  transaction? 
The  second  bank? 

Solution  : 

April  I 

Face  of  note $5,000.00 

Add  interest  for  60  days  at  6% 50.00 

Amount  due  on  note  at  maturity $5,050.00 

Deduct  discount  for  60  days  at  6% 50.50 

Proceeds  received  by  merchant $4,999.50 


458  APPENDIX 

May  I 

Amount  due  on  note  at  maturity $5,030.00 

Deduct  discount  for  30  days  at  6% 25.25 

Proceeds  received  by  first  bank $5,024.75 

Cost  to  first  bank 4,999.50 

Profit  of  first  bank S25.25 

Proceeds  received  at  maturity  by  second  bank $5,050.00 

Cost  to  second  bank 5,024.75 

Profit  of  second  bank $25.25 

9.  (a)  If  a  bill  is  drawn  to  mature  3  months  from  August  25,  when  does 
it  become  due? 

(b)  If  a  bill  is  drawn  to  mature  go  days  from  August  25,  when  does  it 
become  due? 

Solution: 

(a)  November  25,  unless  that  date  falls  on  Sunday  or  a  holiday,  in 
which  case  the  due  date  would  be  the  next  business  day  following  Novem- 
ber 25. 

(b)  November  23,  unless  that  date  falls  on  Sunday  or  a  holiday,  in 
which  case  the  due  date  would  be  the  next  business  day  following  Novem- 
ber 23. 

10.  Find  the  net  proceeds  of  a  90-day  note  for  $1,200  dated  September 
12,  bearing  5  per  cent  intereet  and  discounted  October  7  at  6  per  cent. 

Solution: 

Face  of  note $1 ,200.00 

Add  90  days'  interest  at  5% 15.00 

Amount  due  at  maturity $1,215.00 

Due  date  90  days  from  September  12  is  December  11 

Discounted  October  7  for  65  days 

Discount  for  65  days  at  6%  on  $1,215  is i3-i6 

Net  proceeds $1,201.84 

11.  On  October  26  the  Washburn  Chemical  Company  of  Boston  sold  to 
its  bank  a  60-day  promissory  note  for  $3,000,  dated  October  21  and 
bearing  7  per  cent  interest.  The  bank's  discount  rate  was  7  per  cent. 
What  are  the  proceeds? 


PROBLEMS  WITH  SOLUTIONS  459 

Solution: 

Face  of  7%  60-day  note $3,000.00 

Interest  for  60  days  at  7% 3500 

Amount  due  at  end  of  60  days $3,035.00 

Discounted  October  26  for  55  days  at  7% 3246 

Proceeds $3,002.54 

12.  In  what  time  approximately  will  it  take  a  given  sum  to  double  itself 
at  compound  interest  at  a  given  rate?  For  example,  how  long  would  it 
require  $100  placed  in  a  bank  at  4  per  cent,  interest  compounded  quarterly, 
to  amount  to  S200? 

Solution:  The  following  approximation  formula  is  convenient  for 
obtaining  results  accurate  to  within  less  than  a  year: 

•693    , 

«  =  — h  .35 

1 

where  n  represents  the  number  of  periods  (i  year,  jl^  year,  >^  year,  etc.) 
and  i  represents  the  rate  of  interest  for  a  period.  Solving  the  above  prob- 
lem we  get: 

n  ^  ' — ^  +  .35  =  69.65  periods  of  1/4  vears,  or  17.4  years 
.01 

If  we  divide  70  by  the  rate  of  interest  the  result  is  close  enough  for  most 
practical  purposes  and  the  formula  can  be  remembered  more  easily  when 
thus  simplified. 

13.  Many  banks  advertise  the  payment  of  interest  on  daily  balances 
of  checking  accounts  at  a  nominal  rate,  which  is  commonly  2  per  cent. 
One  method  of  computing  the  interest  is  to  add  together  the  balances  for 
each  day  and  allow  a  i  day's  interest  on  the  total.  For  example,  suppose 
that  the  bank's  account  with  the  ABC  Company  showed  these  facts: 


May 


Deposits 

Wi 

ihdraw 

als 

Balance 

I 

$700 

$... 

$700 

2 

400 

200 

900 

3 

900 

4 

750 

500 

1,150 

5 

360 

400 

1,110 

6 

900 

700 

1,310 

460 

May 


Deposits      Withdrawals  Balance 

7  450  560  1,200 

8  600  450  1,350 

9  525  875  1,000 

10  ...  ...  1,000 

11  875  600  1,275 

12  690  580  1,385 

13  430  800  1,015 

14  510  620  905 

15  770  475  1.200 

16  600  560  1,240 

17  ...  ...  1,240 

18  685  535  1,390 

19  715  650  1,455 

20  565  800  1,220 

21  740  860  1,100 

22  800  600  1,300 

23  910  720  1,490 

24  ...  ...  1,490 

25  760  810  1,440 

26  450  625  1,265 

27  950  700  1,515 

28  1,000  650  1,865 

29  540  890  1,515 

30  760  950  1,325 

31  ...  .••  1-325 


$17,435  $16,110  $38,575 

One  day's  interest  on  $38,575  at  2  per  cent  per  annum  is  $2.11. 

14.  On  January  i,  1922,  $300  is  deposited  in  a  savings  bank  wliich  pays 
4  per  cent  interest,  compounded  semiannually.  What  will  the  deposit 
amount  to  10  years  later? 

Solution:  Refer  in  Appendix  C  to  Table  3,  "Compound  Interest  on 
$1."  Since  interest  is  to  be  compounded  twice  a  year  there  will  be  20 
interest  periods  and  the  interest  rate  is  2  per  cent  per  period.  Therefore, 
if  we  take  the  figure  in  the  table,  opposite  20  periods  and  under  2  per  cent, 
we  find  that  $1  deposited  at  2  per  cent  interest  per  period  will  amount  to 
$1.485947  at  the  end  of  20  periods.  Similarly  $300  will  amount  to 
300  X  $1.485947,  or  $445-78. 


PROBLEMS  WITH  SOLUTIONS  461 

15.  A  father  wishes  to  set  aside  in  a  bank,  at  the  birth  of  his  son,  a  sum 
which  will  accumulate  to  $10,000  by  the  time  the  son  reaches  his  majority. 
Assuming  that  the  bank  rate  of  interest  is  4  per  cent,  compounded  semi- 
annually, what  is  the  sum  required? 

Solution:  Refer  in  Appendix  C  to  Table  4,  "The  Present  Worth  of 
$1."  Since  interest  is  to  be  compounded  semiannually  there  will  be  42 
interest  periods  in  21  years  and  the  semiannual  interest  will  be  2  per  cent. 
Therefore,  if  we  take  the  figure  in  the  table,  opposite  42  periods  and  under 
2  per  cent,  we  find  that  $0.435304128,  set  aside  and  allowed  to  accumulate 
at  2  per  cent  semiannual  interest,  will  amount  to  |i  at  the  end  of  21  years. 

In  order  to  accumulate  $10,000  under  the  same  conditions,  it  would  be 
necessary  therefore  to  set  aside  10,000  times  $0.435304128,  or  $4,353,041. 

16.  A  man  puts  $25  into  a  savings  bank  at  the  end  of  every  month  for 
10  years.  If  the  bank  pays  4  per  cent  interest  per  year,  compounded  semi- 
annually, what  will  the  savings  amount  to  at  the  end  of  10  years? 

Solution:  Refer  in  Appendi-x  C  to  Table  5,  "The  Amount  of  $1  per 
Annum."  Since  interest  is  to  be  compounded  semiannually,  there  will  be 
20  interest  periods  in  10  years  and  the  semiannual  interest  will  be  2  per 
cent.  Therefore,  if  we  take  the  figure  in  the  table,  opposite  20  periods  and 
under  2  per  cent,  we  find  that  $1  set  aside  each  6  months,  at  2  per  cent 
semiannual  interest,  will  amount  to  $24.297370. 

$25  set  aside  each  month,  or  $150  each  6  months,  therefore  amounts  to 
150  X  $24.297370  or  $3,644.61. 

17.  Banking  transactions: 

Puritan  National  Bank 

Resources 

Loans  and  discounts $8,550,000 

United  States  bonds 1,890,000 

Other  bonds  and  securities 1,015,000 

Customers'  liability  account  of  acceptances 315,000 

Stock  in  federal  reserve  bank 60,000 

Banking  house  and  vaults 160,000 

Exchanges  for  the  clearing  house 300,000 

Cash 285,000 

Due  from  banks 700,000 

Interest  earned,  not  collected 30,000 

$1.3.305.000 


462  APPENDIX 

Liabilities 

Capital $1,000,000 

Surplus  and  undivided  profits 1,540,000 

Reserve  for  taxes  and  interest 45.ooo 

Unearned  discount 1 15,000 

National  bank  notes  outstanding 965,000 

Deposits 9,120,000 

Acceptances  executed  for  customers 315,000 

Reserve  for  depreciation  of  securities 150,000 

Reserve  for  depreciation  of  buildings  and  vaults 55. 000 

$13,305,000 

Required:     ]\Iake  such  changes  in  the  above  statement  as  are  necessi- 
tated by  the  following  transactions: 

1.  $10,000   in  cash  received  for  dividends  and  interest  on  stocks  and 

bonds. 

2.  $100,000  received  on  deposit,  of  which  $25,000  is  in  cash  and  $75,000 

in  checks  on  other  banks. 

3.  A  depositor  cashes  his  personal  check  at  the  bank  for  $1,000. 

4.  Payment  of  $30,000  in  cash  on  account  of  taxes. 

5.  Payment  of  $25,000  in  cash  for  salaries. 

6.  Expenditure  of  $15,000  in  cash  for  installing  additional  vaults. 

7.  A  customer,  in  whose  behalf  an  acceptance  credit  of  $20,000  had  been 

granted,  settles  the  transaction  at  maturity  of  acceptance  by  draw- 
ing his  personal  check  on  the  bank  for  $20,050,  covering  the  amount 
of  the  credit  plus  a  commission  of  '4  per  cent.  Bank  pays  holder  of 
acceptance  with  $20,000  draft  on  an  out-of-town  bank. 

8.  $200,000  of  new  bills  and  notes  arc  discounted  for  customers  at  an 

average  rate  of  6  per  cent  per  annum  for  an  average  time  of  3  months . 
Those  receiving  discounts  take  $10,000  in  cash,  and  the  remainder 
of  the  proceeds  is  left  on  deposit. 
g.  $15,000  in  cash  invested  in  municipal  bonds. 

10.  At  the  clearing  house  the  bank  presents  checks  on  other  banks  to  the 
amount  of  $375,000  and  receives  for  settlement  depositors'  checks 
on  itself  for  $600,000.  Settlement  with  the  clearing  house  is  made 
by  drawing  a  check  in  its  favor  on  the  federal  reserve  bank. 

Note:  In  making  the  necessary  changes  called  for  the  above  trans- 
actions, show  only  the  items  that  would  be  affected.  Also 
indicate  by  a  plus  or  minus  sign  the  amount  of  increase  or 
decrease. 


PROBLEMS  WITH  SOLUTIONS 


463 


Solution: 

Resources 

1  Cash +    $10,000 

2  Cash +      25,000 

Exchanges     for 

clearinghouse.    +      75,000 

3  Cash —         1 ,000 

4  Cash —      30,000 

5  Cash —       25,000 

6  Cash —       15,000 

Banking     house 

and  vaults.  .  .  .    +       15,000 

7  Customers'  liabil- 

ity account  of 
acceptances. .  .    —       20,000 
Due  from  banks .    —      2(;),ooo 

8  Loans     and     dis- 

counts      +  200,000 

Cash., -  10,000 

9  Cash —  15,000 

Other  bonds  and 

securities +  15,000 

10         Exchanges     for 

clearinghouse.  —  375,000 

Due  from  banks.  —  225,000 


Liabilities 
Surplus    and    undivided 

profits +    $10,000 

Deposits +     100,000 

Deposits -         1 ,000 

Reserve   for    taxes   and 

interest -       30,000 

Surplus    and    undivided 

profits -       25,000 

Acceptances    executed 

for  customers —  20,000 

Deposits —  20,050 

Surplus    and    undivided 

profits +  50 

Deposits +  187,000 

Unearned  discount +  3,000 

Deposits —    600,000 


18.  Surplus  of  a  Bank:  The  purpose  of  this  problem  is  to  make  clear 
the  meaning  of  "surplus"  on  a  bank's  statement;  to  show  that  surplus 
signifies  the  amount  by  which  total  assets  exceed  capital  stock,  undivided 
profits,  deposits,  and  other  liabilities;  and  to  indicate  that  it  does  not 
represent  anything  tangible,  such  as  a  fund  of  cash,  securities,  or  other 
assets. 

Using  the  statement  of  the  Indian  National  Bank  in  Problem  25, 
indicate  the  changes  that  would  be  required  in  the  statement  as  a  result  of 
the  following  transactions: 

(a)  Reducing  surplus  by  investing  one-half  of  it  in  Liberty  bonds 
purchased  for  cash. 


464  APPENDIX 

(b)  Using  surplus  to  pay  depositors  to  whom  the  bank  owes  $10,000 

on  demand. 

(c)  Transfer  $500,000  of  undivided  profits  to  surplus. 

(d)  Bonds  and  securities  to  the  extent  of  $15,000  are  found  to  be 

worthless  and  are  written  off  the  books. 

(e)  Drawing  upon  surplus  $75,000  to  increase  the  legal  reserve  main- 

tained at  the  federal  reserve  bank. 

(f)  Declaring  and  paying  a  cash  dividend  of  2  per  cent. 

(g)  Declaring  and  distributing  a  stock  dividend  of  50  per  cent. 

Solution:  (a)  This  transaction  as  it  reads  is  impossible.  In  the 
first  place,  the  cash  on  hand  is  less  then  one-half  of  the  surplus,  and,  second, 
if  Liberty  bonds  were  purchased  there  would  be  no  change  whatever  in  the 
surplus  account.  Instead,  "cash"  under  assets  would  be  reduced  and, 
offsetting  this,  "Liberty  bonds"  under  assets  would  be  increased  exactly 
the  same  amount,  thus  making  no  change  in  total  assets  and  no  change 
in  any  liability. 

(b)  This  transaction  is  also  impossible.  Paying  depositors  $10,000 
would  not  affect  surplus,  but  would  instead  reduce  cash  and  deposits  by 
that  amount. 

(c)  Increase  surplus  $500,000  and  decrease  undivided  profits  the  same 
amount.  This  is  merely  a  bookkeeping  operation;  no  cash,  securities,  or 
other  assets  will  be  affected  in  any  way.  Undivided  profits  and  surplus 
are  in  reality  much  the  same  thing.  In  short,  capital  stock,  surplus,  and 
undivided  profits  together  represent  the  net  worth  of  the  stockholders  or 
their  net  claim  against  total  assets. 

(d)  Reduce  bonds  and  securities  $15,000  and  reduce  undivided  profits 
$15,000. 

(e)  This  transaction  is  impossible.  In  order  to  increase  the  legal 
reserve  it  would  be  necessary  either  to  rediscount  more  paper  at  the  federal 
reserve  bank  or  send  the  latter  cash.  The  former  plan,  of  course,  is  the 
more  common  but  under  either  plan  surplus  would  not  be  affected.  In- 
stead, the  item,  "due  from  federal  reserve  bank,"  would  be  increased  and 
either  "notes  rediscounted,"  a  liability,  would  be  increased  or  "cash" 
would  be  decreased. 

(f)  Reduce  cash  $40,000  and  reduce  undivided  profits  $40,000.  The 
dividend  is  actually  paid  out  of  cash  but  this  asset  having  been  reduced, 
the  net  worth  is  smaller  and  therefore  undivided  profits  must  be  reduced. 

(g)  Increase  capital  stock  $1,000,000  and  reduce  surplus  $1,000,000. 
This  is  simply  a  paper  dividend,  the  equity  or  net  worth  of  the  stock- 
holders being  the  same  as  before.    No  asset  is  affected  because  the  bank 


PROBLEMS  WITH  SOLUTIONS  4^5 

neither  receives  nor  parts  with  any  resources,  and  in  case  of  dissolution 
the  residue  for  distribution  to  the  stockholders  would  be  just  the  same  as  if 
no  stock  dividend  had  been  declared. 

19.  A  trust  company  inserted  an  advertisement  in  the  newspapers  to 
the  effect  that  it  was  daily  becoming  a  more  substantial  institution  and 
cited  as  evidence  these  facts: 

Deposits  January  I,  1 92 1 $1,200,000    * 

"         July  I,  192 1 2,000,000 

Question:  Is  the  increase  of  $800,000  in  deposits  necessarily  an 
indication  of  strength? 

Answer  :  No.  On  the  contrary  it  may  be  an  indication  of  weakness. 
In  the  case  of  a  commercial  bank  deposits  arise  principally  from  loans  and 
discounts.  That  is,  customers  obtaining  loans  and  discounts  take  their 
proceeds  in  deposit  accounts  against  which  they  later  draw  checks.  There- 
fore, if  a  bank  should  follow  a  liberal  policy  in  granting  loans  and  discounts 
without  proper  collateral  or  adequate  security  it  could  very  easily  increase 
its  deposits  but  at  the  same  time  weaken  its  financial  position. 

20.  (a)  From  the  following  facts  of  a  manufacturing  plant  determine 
in  two  different  ways  the  merchandise  turnover: 

Cost  price  of  average  merchandise  inventory $60,000 

Average  selling  profit  based  on  cost 25% 

Total  sales $300,000 

(b)  How  long  should  the  commercial  paper  of  this  firm  run?  and  why? 

Solution: 
(a) 

Cost  price  of  merchandise  inventory $60,000 

Cost  price  of  sales  ($300,000  -^  125%) $240,000 

Therefore  turnover  =  $240,000  -r-  $60,000  =  4 

or 

Selling  price  of  merchandise  inventory $75,000 

Sales $300,000 

Therefore  turnover  =  $300,000  -i-  $75,000  =  4 

(b)  Since  turnover  is  4  this  means  that  it  requires  about  90  days  for 
the  average  lot  of  goods  to  be  sold.     The  commercial  paper  therefore 
should  run  ordinarily  not  much  longer  than  90  days. 
30 


^ 


I 


466  APPENDIX 

21.  The  statements  of  a  firm  for  two  successive  years  show  the  follow- 
ing facts: 

1920  1921 

Cash $10,000  $20,000 

Receivables 30,000  60,000 

Merchandise 100,000  120,000 

Total  current  assets $140,000  $200,000 

Accounts  payable $40,000           $60,000 

Other  current  debts 30,000             40,000 

Total  current  liabihties $70,000  $100,000 

Ratio  of  current  assets  to  current  liabilities .  2  to  i            2  to  i 

Ratio  of  merchandise  to  receivables 3  1/3  to  i            2  to  i 

Question:  Assuming  the  moral  risk  and  other  factors  to  have  re- 
mained unchanged,  which  of  these  two  statements  shows  the  stronger 
position  from  the  viewpoint  of  the  lending  banker? 

Answer:  It  is  customary  to  carry  merchandise  at  cost  or  market, 
whichever  is  the  lower,  whereas  receivables  are  listed  at  face  value,  which 
includes  a  profit  on  merchandise  sold.  In  1920  the  ratio  of  merchandise  to 
receivables  is  3  V3  to  i,  whereas  in  1921  the  ratio  is  reduced  to  2  to  i. 
Although  a  higher  current  ratio  might  be  expected  in  192 1  it  remained 
unchanged.  Consequently  the  statement  for  1920  presents  the  stronger 
position,  assuming,  of  course,  that  the  quality  of  the  merchandise  and 
receivables  is  no  better  in  1921  than  in  1920. 

22.  Acme  Chemical  Company 

1918  1921 

Receivables $75.ooo  $125,000 

Sales 475.000  500,000 

Terms 30  days  net  30  days  net 

Question:  In  which  year,  presumably,  is  the  quality  of  the  receiv- 
ables the  higher? 

Answer:  In  1918.  The  ratio  of  receivables  to  sales  is  about  i  to  6  for 
1918  and  I  to  4  for  1921.  This  means  that  customers  owed  the  firm  for 
about  2  months' sales  (Veof  12  months)  in  1918  and  for  about  3  months' 
sales  {}4  oi  12  months)  in  1921,  thus  indicating  slower  collections  and 
probably  more  bad  debts  in  192 1  than  in  1918. 

23.  The  sales  of  a  certain  firm  for  1920  were  $1,440,000  and  its  terms 
were  5  per  cent  discount  in  10  days,  30  days  net. 


PROBLEMS  WITH  SOLUTIONS  4^7 

Question:     What  should  be  the  average  amount  of  the  receivables? 

Solution:  $40,000  or  10  days'  sales.  The  average  monthly  sales 
are  $1 20,000,  which  amounts  to  $40,000  for  10  days.  If  the  customers  arc 
paying  their  bills  promptly  in  order  to  take  advantage  of  the  5  per  cent 
discount,  the  average  amount  of  the  receivables  should  not  represent  more 
than  10  days'  sales.  A  larger  amount  of  receivables  would  ordinarily 
mean  that  the  customers  were  short  of  working  capital  and  were  unable  to 
borrow  necessary  funds  at  their  banks,  and  this  would  probably  eventu- 
ally lead  to  a  large  amount  of  slow  and  uncollectible  accounts. 

24.  If  the  statement  of  the  above  firm  were  as  of  a  date  at  the  peak  of 
the  selling  season,  how  should  the  ratio  of  receivables  to  sales  stand? 

Solution  :  The  ratio  of  receivables  to  sales  would  naturally  be  greater 
and  in  the  case  given  the  receivables  might  increase  to  $80,000  or  $100,000, 
depending  on  the  nature  of  the  business.  For  instance,  in  the  men's 
clothing  industry,  which  has  two  principal  seasons,  a  concern's  receivables 
on  May  i  and  November  i  might  normally  be  almost  equal  to  one-half 
year's  sales. 

25.  Reserve  relations  of  a  member  bank  and  a  federal  reserve  bank: 

Statement  of  Condition  of  Indian  National  Bank 
Resources 

Cash $454,282.04 

Due  from  federal  reserve  bank 3.590,715.47 

Exchanges  for  clearing  house 2,928,884.46 

Due  from  banks  and  trust  companies 1.768,759.57 

United  States  treasury  certificates  of  indebt- 
edness   428,000.00      $9,170,641.54 

Demand  loan $6,162,491.98 

Notes  discounted,  secured  by  Liberty  bonds, 

due  within  90  days 724,100.00 

Notes  discounted,  due  within  90  days 18,136,100.32 

$25,022,692.30 

Notes  discounted  due  within  6  months 5,124,768.87       30,147,461.17 

United  States  Liberty  bonds  and   Victory 

notes $165,103.04 

Other  bonds  and  securities 1,039,829.74 

Stock,  federal  reserve  bank 150,000.00         1,354,932.78 

Customers' liability  account  of  acceptances  executed 921,196.76 

Bank  acceptances  sold  with  indorsement 70,000.00 

$41,664,232.25 


468  APPENDIX 

Liabilities 

Demand  deposits $28,801,860.27 

Time  deposits  subject  to  30  days'  notice 1,410,375.39 

$30,212,235.66 

Acceptances  executed  for  customers 1,081,529.00 

Notes  rediscounted 3,500,000.00 

Indorsement  on  bank  acceptances  sold 70,000.00 

Capital $2,000,000.00 

Surplus 3,000,000.00 

Undivided  profits 1,591,861.74 

Reserved  for  taxes 208,605.85         6,800,467.59 

$41,664,232.25 

Documentary  letters  of  credit  issued  but  not  used  or  drawn 

against $123,295.95 

Travelers'  letters  of  credit  not  drawn  against 90.359-54 


Condition  of  Federal  Reserve  Bank  of  Boston 

Liabilities 


■Resources 

Oct.  19.  1921 

Total  gold $258,526,000 

Legal  tender  and  silver 16,748.000 

Total  cash  reserves $275,274,000 

Discounts  secured  by  United 
States  securities 

Discount^,  commercial  paper 

Bankers'  acceptances  pur- 
chased  

United  States  securities 
against  federal  reserve 
bank  notes 

Other  United  States  securi- 
ties owned 


24,847,000 
46.953,000 


4,500,000 


13,936,000 


730,000 


Total  earning  assets  . . 

Uncollected  items 

Other  resources 


$90,966,000 

59.833.000 

5,254,000 


Total  resources $431,327,000 


Capital 

Surplus 

Deposits:  Government  . 
Member  bank  reserves. 
All  other 


Oct.  19,  1921 

$7,935,000 

19,068,000 

1,699,000 

113,848,000 

968,000 


Total  deposits $116,515,000 


Federal  reserve  notes 

Federal  reserve  bank  notes. . 

Collection  items 

All  Other  liabilities 


231,940,000 

7,906,000 

46,640,000 

1,323.000 


Total  liabilities . 


Reserve  ratio . 


$431,327,000 


79.0% 


Question  i.  During  the  next  six  months  the  Indian  National  Bank 
discounts  at  the  federal  reserve  bank  $10,000,000  of  commercial  paper. 
The  discount  rate  is  5  per  cent  and  the  paper  runs  on  the  average  30  days. 
The  Indian  National  Bank  takes  $200,000  of  the  proceeds  in  federal  reserve 


PROBLEMS  WITH  SOLUTIONS  469 

notes  and  leaves  the  remainder  on  deposit.    Show  the  necessary  changes  in 
the  statements  of  the  federal  reserve  bank  and  the  member  bank. 

Question  2.  (a)  If  member  banks  take  all  of  their  rediscounts  in 
federal  reserve  notes  how  much  additional  paper  could  this  federal  reserve 
bank  rediscount  for  its  members,  assuming  that  it  docs  not  borrow  at  other 
federal  reserve  banks?  For  purposes  of  illustration  make  no  allowance  for 
the  small  discount  charge  which  in  actual  practice  would  be  deducted 
from  the  face  of  the  commercial  paper  before  determining  the  proceeds 
available  for  the  member  banks.  Also  start  with  the  statement  of  the 
federal  reserve  bank  given  at  the  beginning  of  the  problem. 

(b)  Answer  the  same  question  as  under  (a),  assuming  that  the  member 
banks  leave  all  of  their  rediscounts  on  deposit. 

(c)  Answer  the  same  question  as  under  (a),  assuming  that  the  member 
banks  take  i/io  of  their  rediscounts  in  federal  reserve  notes  and  leave  the 
remainder  on  deposit. 

Solution  i: 

5%  discount  on  $10,000  for  30  days  on  365-day  basis  is  $41 ,096 

Proceeds  of  $10,000,000  paper   is 9,958,904 

Indian  National  Bank  takes  in  federal  reserve  notes . .  200,000 

Leaving  on  deposit  balance  of  proceeds $9,758,904 

Changes  in  Indian  National  Bank's  statement: 

Resources 
Cash  increased $200,000 

Due  from  federal  reserve  bank  increased 9,758,904 

Total  resources  increased $9,958,904 

Liabilities 

Notes  rediscounted  increased $10,000,000 

Undivided  profits  decreased 41,096 

Total  liabilities  decreased $9,958,904 

Changes  in  federal  reserve  bank's  statement: 

Resources 

Discounts,  commercial  paper  increased $10,000,000 

Total  resources  increased $10,000,000 


470  APPENDIX 

Liabilities 

Surplus  increased $41,096 

Deposits:  member  bank  reserves  increased 9,758,904 

Federal  reserve  notes  increased 200,000 

Total  liabilities  increased $10,000,000 

Reserve  ratio  now  is  76.8  per  cent.  This  is  found  by  dividing  the  total 
cash  reserves  of  $275,274,000  by  the  sum  of  the  total  deposits,  which  are 
now  $126,273,904,  and  the  federal  reserve  notes,  which  are  now  $232,140,- 
000;  or  $275,274,000  -^  358,413,904. 

Solution  2:  Federal  reserve  banks  are  required  to  maintain  a  mini- 
mum gold  reserve  of  40  per  cent  against  federal  reserve  notes  outstanding 
and  a  minimum  cash  reserve  of  35  per  cent  against  deposits.  In  the  com- 
putation below  the  following  abbreviations  have  been  used  to  refer  to  items 
in  the  statement  of  the  Federal  Reserve  Bank  of  Boston: 

F.R.N,  for  federal  reserve  notes,  $231,940,000 
T.G.        "  total  gold,  $258,526,000 
T.D.        "  total  deposits,  116,515,000 
T.C.R.    "  total  cash  reserves,  $275,274,000 

(a)  Let  X  =  amount  of  additional  paper  that  could  be  rediscounted. 
Then: 

[$231,940,000  (F.  R.  N.)  -H  x]  .40  =  $258,526,000  (T.  G.)  -  $24,032,- 
250  (amount  of  gold  necessary  to  be  added  to  legal  tender  and 
silver  to  produce  cash  reserve  of  35%  against  deposits) 

Therefore: 

X  •=  $354,294,375,  Answer 
Proof: 

$231,940,000  (F.  R.  N.) 

4-    354,294,375,  additional  notes 

$586,234,375    total  notes 

.40,  (40%  gold  reserve) 

$234,493,750,  (total  gold  $258,526,000  —  $24,032,250,  the  amount 
necessary  to  be  added  to  legal  tender  and  silver 
to  produce  reserve  of  35  per  cent  against  deposits) 

(b)  Let  X  =  amount  of  additional  paper  that  could  be  rediscounted. 
Then: 


PROBLEMS  WITH  SOLUTIONS  47 1 

[$116,515,000  (T.  D.)  +  x]  .35  =  $275,274,000  (T.  C.  R.)  -  $92,- 
776,000  (40%  of  gold  reserve  against  notes  already  outstanding) 

Therefore: 

X  =  $404,907,857,  Answer 

Proof: 

$116,515,000,  (T.  D.) 
+    404,907,857,  additional  deposits 

$521,422,857,  new  total  deposits 
•35.  (35%  cash  reserve) 

$182,498,000,  (total  cash  reserves  $275,274,000  —  $92,776,000, 
the  40%  gold  reserve  against  notes  already 
outstanding) 

(c)  Let  X  =  amount  of  additional  paper  that  could  be  rediscounted. 
Then: 

$275,274,000  (T.  C.  R.)  -  .40  [$231,940,000  (F.  R.  N.)]  -  .40  (i  /lo 
x)  =  .35  [$116,515,000  (T.  D.)  +  .90  a:] 

Therefore:  • 

X  =  $399,204,929,  Answer 

Proof: 

$231,940,000   (F.  R.  N.) 
+       39,920,493,  additional  notes  (i/io  of  new  paper) 

$271,860,493,  new  total  notes 

.40,  (40%  gold  reserve) 

(i)  $108,744,197,  gold  reserve  against  notes 

$116,515,000   (T.  D.) 
+     359,284,436,  additional  deposits  (9/10  of  new  paper) 

$475,799,436,  new  total  deposits 
•35.  (35%  cash  reserve) 
(2)  $166,529,803,  cash  reserve  against  new  total  deposits 

Adding  (i)  and  (2): 

$108,744,197 
166,529,803 

$275,274,000,  total  cash  reserves 


472  APPENDIX 

26.  Relationof  gold  to  loans  and  discounts:  "  Yesterday  there  arrived 
in  New  York  on  the  steamship  'Roumania'  $9,100,000  in  gold  to  be  de- 
livered to  the  i8th  National  Bank."  The  i8th  National  Bank  deposits  all 
of  this  gold,  with  the  Federal  Reserve  Bank  of  New  York. 

(a)  How  much  additional  paper  can  the  federal  reserve  bank  now  re- 
discount for  its  members,  assuming  that  the  latter  leave  the  entire  pro- 
ceeds of  the  rediscounts  on  deposit  to  the  credit  of  their  reserves? 

(b)  How  much  additional  loans  can  member  banks  make  to  their  cus- 
tomers on  the  basis  of  the  increase  in  reserves  as  a  result  of  rediscounting 
paper  at  the  federal  reserve  bank  as  described  under  (a)? 

Solution:  (a)  Against  balances  due  its  member  banks  a  federal  re- 
serve bank  must  maintain  a  cash  reserve  of  35  per  cent.  Therefore, 
$9,100,000  in  gold  would  enable  the  Federal  Reserve  Bank  of  New  York 

•        ,  •  ,         •      ,     ,  J  u       u       1        $0,100,000, 

to  increase  its  deposits,  that  is,  balances  due  member  banks, or 

35  per  cent 

$26,000,000.  Disregarding  discount  charges,  the  Federal  Reserve  Bank 
of  New  York  can  now  rediscount  for  its  members  additional  paper  to  the 
extent  of  $26,000,000 — $9,100,000  (the  gold  itself  will  constitute  a  part  of 
the  deposits),  or  $16,900,000. 

(b)  The  answer  to  this  question  will  vary  depending  upon  the  location 
of  the  member  banks.  Those  member  banks  which  are  located  in  New 
York  City  may  increase  their  loans  to  such  a  point  that  the  resulting  de- 
mand deposits  are  covered  by  a  13  per  cent  reserve  at  the  Federal  Reserve 
Bank  of  New  York.  Banks  located  in  Albany,  Buffalo,  and  other  reserve 
cities  must  maintain  10  per  cent  reserves,  the  ratio  for  country  banks 
being  7  per  cent.  Against  time  deposits  which  are  relatively  small,  member 
banks  must  maintain  reserves  of  3  per  cent.  For  the  sake  of  simplicity,  if 
we  take  an  average  of  10  per  cent  for  all  member  banks  an  increase  in  their 
reserves  of  $26,000,000  would  enable  them  to  increase  their  loans  to  cus- 

$26,000,000 

tomers  to  the  extent  of  approximately  or  $260,000,000,   or 

10  per  cent 

almost  30  times  the  original  gold.    This  figure,  of  course,  is  a  theoretical 

maximum,  but  it  gives  some  idea  of  the  relation  of  gold  to  inflation  during 

and  immediately  following  the  war. 

27.  The  Washburn  Chemical  Co.  of  Boston  on  October  15  presented 
at  the  Hub  National  Bank  for  collection  trade  acceptances  as  follows: 

(a)  $10,000  drawn  at  30  days  after  sight  on  Baker  and  Jones,  Spring- 
field, Mass. 

(b)  $8,000  drawn  at  60  days  after  sight  on  Henry  Allen,  Providence. 


PROBLEMS  WITH  SOLUTIONS  473 

(c)  $15,000  drawn  at  30  days  after  date  October  15,  on  Garland 
Brothers,  Woicester. 

The  Hub  National  Bank  immediately  forwards  the  drafts  to  its  cor- 
respondents who  present  them  to  the  drawees  for  acceptance;  the  corre- 
spondent banks  then  hold  the  acceptances  until  maturity  for  payment. 
On  October  17  the  Hub  National  Bank  notifies  the  Washburn  Chemical 
Company  that  its  three  drafts  have  been  accepted  as  of  October  16.  On 
October  20  the  Washburn  Chemical  Company  arranges  with  the  Hub 
National  Bank  to  discount  this  paper  at  7  per  cent.  What  will  be  the 
total  proceeds  received  by  the  Washburn  Chemical  Company? 

Solution: 

(a)  Amount  of  acceptance,  $10,000 

Date  accepted  October  16 

Due  November  15 

Discounted  October  20,  at  7%  for  26  days: 

6%  on  $10,000  for  30  days $50.00 

Add  1/6 8.33 

7%  for  30  days $58-33 

26 

—  of  $58.33 $50.55 

30 


$10,000.00 
—50.55 


Proceeds  of  (a) $9,949.45 


(b)  Amount  of  acceptance,  $8,000 

Date  accepted  October  16 

Due  December  15 

Discounted  October  20  for  56  days  at  7%: 

6%  for  60  days $80.00 

Add  1/6 13-33 

7%  for  60  days $93-33 

56 

7-  of  $93-33 $87-11 

60 


5,000.00 
-87.11 


Proceeds  of  (b) $7,912.89 


474  APPENDIX 

(c)  Amount  of  acceptance,  $15,000 

Date  accepted  October  16  1 

Due  November  14 

Discounted  October  20  for  25  days  at  7%: 

6%  for  30  days $75-00 

Add  1/6 12.50 

7%  for  30  days $87.50 

—  of  $87.50 $72.92 

30  

$15,000.00 
—  72.92 

Proceeds  of  (c) $14,927.08 

Proceeds  of  (b) 7,912.89 

Proceeds  of  (a) 9,949.45 

Total  proceeds $32,789.42 

28.  On  October  i  the  Washburn  Chemical  Company  of  Boston  bought 
a  lot  of  goods  amounting  to  $75,000  from  a  firm  in  Newark,  New  Jersey. 
According  to  the  terms  of  the  sale  the  buyer  opens  a  60  days'  credit  at 
the  Hub  National  Bank  in  favor  of  the  Newark  firm.  After  having  made 
shipment  the  Newark  firm  on  October  21  draws  a  draft  at  60  days  after 
date  on  the  Hub  National  Bank  and  attaches  to  it  the  bill  of  lading.  The 
draft  is  accepted  on  October  22.  On  October  25  the  Newark  firm  arranges 
with  its  local  bank  to  discount  the  bank  acceptance  at  ()%  per  cent.  What 
are  the  proceeds? 

Solution: 

Amount  of  draft,  $75,000 

Date  accepted  October  22 

Due  December  20 

Discounted  October  25  for  56  days  at  6  1/2%: 

6%  for  60  days $750.00 

Add  1/12 62.50 

6  1/2%  for  60  days $812.50 

S6 

—  of  $812.50 $758.33 

00 


$75,000.00 

-758.33 

Proceeds $74,241.67 


PROBLEMS  WITH  SOLUTIONS  475 

29.  The  following  statements  have  been  taken  in  part  from  the  weekly 
foreign  section  of  a  financial  publication.  Supply  in  each  of  the  blank 
spaces  the  word  ''advance"  or  "decline"  with  the  necessary  modifications 
as  the  case  may  require. 

(a)  Leading  European  banks  lowered  their  discount  rates  and  ex- 
change   . 

(b)  There  was  a  good  supply  of  commercial  bills,  especially  against 
cotton,  and  exchange . 

(c)  Merchandise  exports  were  large,  but  in  the  previous  months  bills 
had  been  drawn  against  future  shipment  of  goods,  and  consequently 
exchange  did  not . 

(d)  There  was  a  belief  that  the  Morgan  syndicate  would  get  a  large 
part  of  the  $50,000,000  new  issue  of  New  York  City  bonds  to  be  placed 
abroad,  and  exchange . 

(e)  American  securities  were  sold  in  New  York  for  European  acount, 
and  exchange . 

(f)  A  slight  — in  exchange  was  caused  by  the  placing  abroad  of 

some  choice  investment  securities. 

(g)  Exchange  dealers  sought  to  cover  for  contracts  for  future  delivery 
of  exchange  made  earlier  in  the  year  and  which  are  now  maturing;  as  a 
result,  exchange . 

(h)  Rates ,  mainly  as  the  result  of  drawing  against  credit  which 

had  been  established  abroad  through  the  previous  sales  of  considerable 
blocks  of  railway  stock. 

(i)  Political  unrest  in  Europe  and  the  probable  issue  of  government 
loans  by  France,  led  to  a in  exchange. 

(j)  A  severe  monetary  stringency  in  New  York  led  to  American  banks 
drawing  on  their  balances  in  European  banks,  and  exchange . 

Answer: 

(a)  Advanced  (f)   Decline 

(b)  Declined  (g)  Advanced 

(c)  Decline  (h)  Declined 

(d)  Declined  (i)    Decline 

(e)  Advanced  (j)    Declined 

30.  The  Atlantic  Export  Company  of  Boston  has  sold  some  merchan- 
dise to  a  firm  in  Copenhagen.  The  latter's  bank  has  arranged  with  its 
London  correspondent  for  the  acceptance  of  90-day  sight  bills  properly 
drawn  and  with  the  necessary  documents  attached  to  the  amount  of  £3 ,000 . 

What  are  the  proceeds  which  the  Boston  banker  will  pay  the  Atlantic 


476  APPENDIX 

Export  Company  for  their  90-day  bill  of  £3,000  if  the  demand  rates  for 
bankers'  checks  on  London  ar^  quoted  at  $4.40,  the  London  discount  rate 
for  Qo-day  bills  is  6  per  cent,  and  the  English  stamp  charges  are  1/20  per 
cent  of  face  of  bill?  Allow  the  Boston  banker  as  a  margin  of  profit  yi 
cent  per  £. 

In  England  365  days  are  always  used  as  the  basis  of  computing  dis- 
count.   On  30,  60,  and  90-day  sight  bills,  3  days  of  grace  are  allowed. 

Solution: 

Basis  £100 $440.00 

Deduct  discount,  93  days'  interest,  at  6% $6.73 

Deduct  English  stamp  charges  at  1/20% 0.22 

Deduct  Boston  banker's  margin  of  profit,  1/4 

cent  per  £ 0.25 

Total  deductions  per  £100 7-20 

Proceeds  per  £100 $432.80 

Rate  per  £  for  90-day  bill 4-328 

Proceeds  from  sale  of  90-day  bill  for  £3,000. $12,984.00 


APPENDIX  B 
PROBLEMS  WITHOUT  SOLUTIONS 

31.  A  mining  company  sends  to  the  United  States  Mint  12,000  ounces 
of  gold  .Q25  fine.  The  mint  charges  2  cents  an  ounce  for  removing  the 
impurities.  The  gold  is  coined  in  pieces  of  standard  fineness.  The  only 
other  charge  that  is  made  is  2>^  cents  per  ounce  for  the  copper  alloy. 
How  much"  gold  will  the  company  receive? 

32.  Suppose  that  the  weight  of  the  gold  dollar  is  decreased  i  per  cent. 
What  will  be  the  price  of  gold  per  fine  ounce? 

33.  Suppose  that  the  weight  of  the  gold  dollar  is  decreased  i  per  cent. 
What  will  be  the  par  of  exchange  with  England?    With  France? 

34.  Suppose  that  the  gold  dollar  is  lo/i  i  fine,  with  no  change  in  weight. 
What  will  be  the  mint  price  of  gold  per  fine  ounce? 

35.  Suppose  that  the  gold  dollar  is  lo/i  i  fine,  with  no  change  in  weight. 
What  will  be  the  par  of  exchange  with  England?    With  France? 

36.  (a)  If  $150  of  gold  coin  is  melted  what  will  the  gold  bullion  be 
worth? 

(b)  If  $150  in  silver  dollars  is  melted  what  will  the  silver  bullion  be 
worth?    Use  latest  market  price  for  metal. 

Assume  in  each  case  that  the  gold  and  silver  coins  are  full  weight  and 
have  not  been  worn  from  circulation. 

(c)  Answer  the  same  question  for  silver  assuming  that  money  is  in  the 
form  of  subsidiary  silver  instead  of  dollar  pieces. 

37.  A  merchant  negotiates  a  loan  at  his  bank  by  discounting  a  60-day 
non-intcrcst-bearing  note  for  $6,000  which  has  been  received  from  a  cus- 
tomer. The  note  is  discounted  at  6  per  cent  on  the  day  it  is  received  and 
the  borrower  agrees  to  maintain  a  deposit  balance  of  20  per  cent  of  the 
loan,  or,  say,  $1,200. 

(a)  What  is  the  real  rate  of  interest  paid  by  the  borrower,  assuming 
that  the  bank  pays  no  interest  on  deposit  balances? 

(b)  Answer  the  same  question,  assuming  that  the  bank  pays  2  per 
cent  interest  on  the  deposit  balance,  which  averages  $1,200. 

38.  On  June  15  a  merchant  presents  for  discount  at  his  bank  a  note 
dated  the  same  day  for  $7,000  due  in  60  days.    The  note  bears  7  per  cent 

477 


478  APPENDIX 

interest  and  the  bank's  rate  of  discount  is  7  per  cent.     What  will  the  note 
yield  to  the  merchant? 

On  July  3  the  bank  sells  the  note  to  another  bank  on  a  6  per  cent  dis- 
count basis.  What  profit  will  the  first  bank  make  by  the  transaction? 
The  second  bank? 

39.  (a)  If  a  bill  is  drawn  to  mature  2  months  from  February  18,  when 
does  it  become  due? 

(b)  If  a  bill  is  drawn  to  mature  60  days  from  February  18,  when  does  it 
become  due? 

40.  Find  the  net  proceeds  of  a  60-day  note  for  $800  dated  July  21, 
bearing  6  per  cent  interest  and  discounted  July  28  at  5^  per  cent. 

41.  On  June  25  Dixon  Brothers  discounted  at  their  bank  a  90-day 
promissory  note  for  $2,500,  dated  June  15  and  bearing  6  per  cent  interest. 
The  bank's  discount  rate  is  6  per  cent.    What  are  the  proceeds? 

42.  Determine  the  approximate  time  it  will  take  for  the  following 
sums  to  double,  triple,  and  quadruple  themselves: 

$100  at  4  per  cent  interest,  interest  compounded  semiannually. 
$300  at  5  per  cent  interest,  interest  compounded  quarterly. 
$600  at  5>^  per  cent  interest,  interest  compounded  monthly. 

-  43.  On  July  I,  1922,  $600  is  deposited  in  a  savings  bank  which  pays 
4>^  per  cent  interest,  compounded  semiannually.  What  will  the  deposit 
amount  to  15  years  later? 

V  44.  A  father  wishes  to  set  aside  in  a  bank,  at  the  birth  of  his  son,  a  sum 
which  will  accumulate  to  $7,500  by  the  time  his  son  reaches  his  majority. 
Assuming  that  the  bank  rate  of  interest  is  4  per  cent,  compounded  semi- 
annually, what  is  the  sum  required? 

45.  A  man  puts  $20  into  a  savings  bank  at  the  end  of  every  month  for 
15  years.  If  the  bank  pays  4  per  cent  interest,  compounded  semiannually, 
what  will  the  savings  amount  to  at  the  end  of  15  years? 

46.  Make  such  changes  in  the  statement  of  the  Puritan  National 
Bank,  shown  in  Problem  1 7,  as  are  necessitated  by  the  following  trans- 
actions: 

(a)  $25,500  invested  in  stocks  and  bonds. 

(b)  $1,000  cash  received  for  dividends  and  interest  on  stocks  and 
bonds. 

(c)  $125,000  of  new  bills  and  notes  discounted  at  an  average  rate  of 
5  per  cent  per  annum  and  for  an  average  time  of  4  months.    Those  receiv- 


PROBLEMS  WITHOUT  SOLUTIONS  479 

ing  loans  take  $10,000  in  notes  of  the  bank,  $5,000  in  legal  tender,  and  the 
remainder  in  the  form  of  deposit  accounts. 

(d)  $3,500  in  the  notes  of  the  bank  are  presented  for  redemption. 

(e)  At  the  clearing  house  the  bank  presents  checks  on  other  banks  to 
the  amount  of  $250,000  and  receives  for  settlement  depositor's  checks  on 
itself  for  $325,000. 

(f)  Bank  sells  at  par  a  New  York  bank  draft  of  $500  to  a  depositor  who 
pays  with  his  check. 

(g)  Of  the  notes  and  bills  discounted  in  (c),  $20,000  are  renewed  for  an 
average  time  of  3  months  at  a  discount  rate  of  5  per  cent  per  annum,  the 
discount  being  paid  by  depositors  drawing  checks  against  their  bank  bal- 
ances, $45,000  are  paid  at  maturity  in  checks  on  other  banks,  and  the 
remainder  are  settled  by  depositors  drawing  checks  against  their  bank 
balances. 

47.  Point  out,  with  a  brief  explanation  in  each  case,  which  of  the 
following  transactions  would  affect  and  which  would  not  affect  the  surplus 
in  the  statement  of  the  Puritan  National  Bank  shown  in  Problem  17: 

(a)  Payment  of  salaries. 

(b)  Putting  a  new  wing  on  the  building. 

(c)  Payment  of  insurance  on  building. 

(d)  Increasing  legal  reserve  against  deposits. 

(e)  Declaring  but  not  paying  a  cash  dividend. 

(f)  Writing  off  a  worthless  account. 

(g)  Issuing  additional  stock  at  a  5  per  cent  premium. 

48.  Bank  A  advertises  that  during  the  past  year  its  deposits  increased 
35  per  cent.  Bank  B's  deposits  increased  6  per  cent.  Both  of  these  in- 
stitutions are  commercial  banks.  Do  these  facts  throw  any  light  on  the 
comparative  strength  of  the  two  banks?     Explain. 

49.  From  the  following  facts  of  a  manufacturing  concern  determine  in 
two  different  ways  the  merchandise  turnover: 

Cost  price  of  average  merchandise  inventory $90,000 

Average  selling  profit  (based  on  selling  price) 40  per  cent 

Total  sales $450,000 

How  long  should  the  commercial  paper  of  this  concern  run?  Give 
reason. 

50.  The  statements  of  a  firm  for  two  successive  years  show  the  follow- 
ing facts: 


48o  APPENDIX 

1921  1922 

Cash $15,000  $10,000 

Receivables 95.ooo  60,000 

Merchandise 190,000  180,000 

Total  current  assets $300,000  $250,000 

Accounts  payable $50,000  $45,000 

Other  current  liabilities 100,000  80,000 

Total  current  liabilities $150,000  $125,000 

Assuming  that  the  moral  risk  and  other  factors  have  remained  un- 
changed, which  of  the  two  statements  show  the  stronger  position  from  the 
viewpoint  of  the  lending  banker? 

51.  Electric  Manufacturing  Company 

1920  1922 

Receivables $130,000  $180,000 

Sales 400,000  850,000 

Terms 30  days  net  30  days  net 

In  which  year,  presumably,  is  the  quality  of  the  receivables  the  higher? 
Explain  briefly. 

52.  The  sales  of  a  certain  firm  for  the  past  year  were  $800,000  and  its 
terms  were  5  per  cent  discount  for  payment  within  10  days,  30  days  net. 
What  should  be  the  average  amount  of  receivables?  Assuming  that  the 
firm  has  two  main  selling  seasons,  how  large  might  the  receivables  become 
without  indicating  signs  of  weakness?  Explain  and  point  out  what  these 
signs  of  weakness  are. 

53.  In  working  out  this  problem  refer  to  the  statements  of  the  Indian 
National  Bank  and  the  Federal  Reserve  Bank  of  Boston  shown  in  Problem 
25.  The  Indian  National  Bank  discounts  at  the  federal  reserve  bank 
$6,500,000  of  commercial  paper.  The  discount  rate  is  5  per  cent  and  the 
paper  runs  on  the  average  45  days.  The  Indian  National  Bank  takes 
$100,000  of  the  proceeds  in  federal  reserve  notes  and  leaves  the  remainder 
on  deposit.  Calculate  the  necessary  changes  in  the  statements  of  the 
federal  reserve  bank  and  the  member  bank,  including  the  federal  reserve 
ratio. 

54.  The  Federal  Reserve  Bank  of  New  York  receives  $5,000,000  of  gold 
deposits. 

(a)  If  member  banks  take  all  of  their  rediscounts  in  federal  reserve 
notes  how  much  additional  paper  can  the  reserve  bank  rediscount  for  its 


PROBLEMS  WITHOUT  SOLUTIONS  48 1 

members,  assuming  that  it  does  not  borrow  at  other  reserve  banks?    Make 
no  allowance  for  discount  charges. 

(b)  Answer  the  same  question,  assuming  that  member  banks  leave  all 
of  their  rediscounts  on  deposit. 

(c)  Answer  the  same  question,  assuming  that  member  banks  take  1/20 
of  their  rediscounts  in  federal  reserve  notes  and  leave  the  remainder  on 
deposit. 

55.  "Yesterday  there  arrived  in  New  York  on  the  steamship  'City  of 
Naples'  $2,000,000  in  gold  to  be  delivered  to  the  Hood  National  Bank." 
The  Hood  National  Bank  deposits  all  of  this  gold  with  the  Federal  Reserve 
Bank  of  New  York. 

(a)  How  much  additional  paper  can  the  federal  reserve  bank  now  re- 
discount for  its  members,  assuming  that  the  latter  leave  the  entire  pro- 
ceeds on  deposit  to  the  credit  of  their  reserves? 

(b)  How  much  additional  loans  can  member  banks  make  to  their  cus- 
tomers on  the  basis  of  the  increase  in  reserves  as  a  result  of  rediscounting 
paper  as  described  under  (a)? 

56.  On  September  28,  John  Jones,  of  Boston,  sold  R.  M.  Smith  of 
Worcester,  machinery  amounting  to  $2,480,  less  20,  25,  and  10  per  cent. 
Terms:  one-half,  60-day  note  with  interest  at  6  per  cent;  one-half  on  ac- 
count, 60  days.    What  was  the  amount  of  the  note  when  received? 

On  October  12  Jones  discounted  at  the  Tenth  National  Bank,  at  6 
per  cent.  Smith's  note  dated  September  28,  the  bank  giving  credit  for  the 
proceeds.  If  the  bank  charges  i/io  per  cent  for  collecting  out-of-town 
paper,  what  was  the  amount  of  the  proceeds  credited? 

57.  Explain  the  following  operations: 

Adams  and  Company  of  Boston,  dealers  in  dry  goods,  arrange  with  the 
Hub  National  Bank  to  accept  a  draft  for  $28,000  payable  in  90  days  from 
date  of  October  i,  the  bank  receiving  ^4  per  cent  of  the  face  of  the  accept- 
ance for  the  privilege  of  so  doing.    The  bank  was  given  satisfactory  security. 

Adams  and  Company  then  sold  the  acceptance  back  to  the  Hub  Na- 
tional Bank  on  the  same  day  at  6  per  cent  discount,  receiving  the  face  of 
the  draft  less  the  discount,  and  this  amount  was  placed  to  the  credit  of 
Adams  and  Company.  On  October  31  the  Hub  National  Bank  sold  the 
acceptance  to  the  Massachusetts  National  Bank  at  5^  per  cent  discount. 
On  November  30  the  Massachusetts  National  Bank  sold  the  acceptance 
to  the  Worcester  National  Bank  at  a  discount  of  5>^  per  cent.  How  much 
profit  did  the  Hub  National  Bank  make,  and  how  much  the  Massa- 
chusetts National  Bank? 
31 


482  APPENDIX 

58.  The  following  statements  have  been  taken  in  part  from  the  weekly 
foreign  section  of  a  financial  publication.  Supply  in  each  of  the  blank 
spaces  the  word  "advance"  or  "decline"  with  the  necessary  modifications 
as  the  case  may  require. 

(a)  It  was  claimed  in  some  quarters  that  the  action  of  the  Federal 
Reserve  Board  in  urging  curtailment  of  borrowing  at  the  federal  reserve 
banks  had  led  to  the  unloading  of  a  large  volume  of  sterling  bills  by  ex- 
porters who  felt  doubtful  of  their  ability  to  carry  these  bills,  thus  causing 
exchange  to . 

(b)  In  part,  the  rapid in  sterling  rates  was  due  to  hurried  cover- 
ing of  outstanding  short  contracts,  induced  by  the  altered  financial  out- 
look. 

(c)  The in  sterling    was    correctly   interpreted  as  reflecting 

marked  improvement  in  Great  Britain's  economic  and  financial  position. 

(d)  There  were  large  additional  arrivals  of  gold  from  London,  and  there 
were  also  reports  of  more  consignments  in  prospect,  but  they  had  no  effect 
in  arresting  the  movement  of  exchange. 

(e)  Offerings  of  commercial  bills  continued  heavy,  and  there  appeared 
to  be  an  utter  lack  of  buying  power,  and  exchange  consequently . 

(f)  In  explaining  the  in  exchange  on  Argentina  it  was  said 

that  a  large  amount  of  merchandise  had  accumulated  in  the  Buenos  Aires 
Custom  House  and  that  Argentine  consignees  were  declining  to  remove  it, 

owing  to  extensive  losses  incurred  on  it  through  the in  the  American 

dollar. 

(g)  During  November  silver  declined  steadily  causing  Far  Eastern 
exchanges  to . 

(h)   Greek  exchange  as  a  result  of  intimations  by  the  allied 

powers  that  no  further  financial  aid  would  be  extended  to  Greece  in  the 
event  of  King  Constantine's  return  to  the  throne. 

(i)  Leading  European  banks  raised  their  discount  rates  and  exchange 


APPENDIX  C 

INTEREST  TABLES' 

Interest  tables  showing  interest  on  $i,ooo,  360-days-to-the- 
year  basis  and  365-days-to-the-year  basis;  also  tables  showing 
the  amount  of  $1  at  compound  interest,  the  present  worth  of  $1 
due  at  some  future  period,  and  the  amount  of  $1  set  aside  each 
period  for  a  number  of  periods  are  given  on  the  following  pages. 

In  the  United  States  it  is  the  common  banking  practice  to 
compute  interest  and  discount  on  the  basis  of  30  days  to  the 
month  and  360  days  to  the  year,  with  no  days  of  grace.  Federal 
reserve  banks,  however,  use  the  365-day  method.  For  sterling 
exchange  calculations,  interest  and  discount  are  figured  on  the 
basis  of  365  days  to  the  year,  with  3  days  of  grace  allowed  on 
promissory  notes  and  bills  of  exchange  or  drafts,  except  those 
drawn  payable  at  sight,  as  in  the  case  of  bankers'  checks. 

These  tables  are  greatly  condensed  from  similar  ones  used  in 
banking  practice  and  have  been  selected  primarily  to  serve  as  an 
aid  in  the  solution  of  problems  presented  in  the  appendices  and 
elsewhere,  or  which  the  instructor  may  devise. 


'Adapted    from    Montgomery    Rollins,    Interest    Tables,    through    courtesy    of    the 
Financial  Publishing  Company,  Boston. 


483 


484  APPENDIX 

Table  i. — Interest  Calculated  on  Basis  of  360  Days 


Interest  on  $i,ooo 


TO  THE  Year 

Day  to  I  Month 


Days 

4% 

4  I '4% 

4  1/2% 

S% 

5  I '2% 

6% 

6  1/2% 

-% 

7  1/2% 

$ 

$ 

$ 

$ 

s 

$ 

S 

$ 

5 

I 

O.I  I  II 

0.1 181 

0.1250 

0.1389 

0.1528 

0-1667 

0.1806 

0-1944 

0-2083 

2 

0.2222 

0.2361 

0.25CO 

0.2778 

0.3056 

0.3333 

0.3611 

0.3889 

0.4167 

3 

0.3333 

C.3542 

0.3750 

0.4167 

0.4583 

0.5000 

0.5417 

0.5833 

0.6250 

4 

0.4444 

0.4722 

0.50CO 

0.5556 

0.61 1 1 

0.6667 

0.7222 

0.7778 

0.8333 

S 

0.5556 

0.5903 

0.6250 

0-6944 

0.7639 

0.8333 

0.9028 

0.9722 

1. 0417 

6 

0.6667 

0.7083 

0.7500 

0.8333 

0.9167 

1. 0000 

1-0833 

1. 1667 

1.2500 

7 

0.7778 

0.8264 

0.8750 

0.9722 

1.0694 

1. 1667 

1.2639 

I-3611 

1.4583 

8 

0.8889 

0.9444 

1. 0000 

I.I  II I 

1.2222 

1-3333 

1-4444 

1-5556 

1.6667 

9 

1. 0000 

1.0625 

1. 1250 

1.2500 

1-3750 

1.5000 

1.6250 

I-75OC 

1.8750 

10 

I. nil 

1. 1806 

1.2500 

1.3889 

I-S278 

1.6667 

1.8056 

1.9444 

2.0833 

II 

1.2222 

1.2986 

1-3750 

1-5278 

1.6806 

1-8333 

1. 9861 

2.1389 

2.2917 

12 

1.3333 

1. 4167 

1.5000 

1.6667 

1.8333 

2.0000 

2.1667 

2.3333 

2.5000 

13 

1.4444 

1.5347 

I-6250 

1.8056 

1. 9861 

2.1667 

2.3472 

2.5278 

2.7083 

14 

1.5556 

1.6528 

1.7500 

1.9444 

2.1389 

2.3333 

2.5278 

2.7222 

2.9167 

IS 

1.6667 

1.7708 

1.8750 

2.0833 

2.2917 

2.5000 

2.7083 

2.9167 

3-1250 

16 

1.7778 

1.8889 

2-0000 

2.2222 

2.4444 

2.6667 

2.8889 

3. nil 

3-3333 

17 

1.8889 

2.0069 

2.1250 

2.3611 

2.5972 

2.8333 

3-0694 

3-3055 

3-5417 

18 

2.0000 

2.1250 

2.2500 

2.S000 

2.7500 

3.0000 

3-2500 

3-5000 

3-7500 

19 

2.1  III 

2.2431 

2.37S0 

2.6389 

2.9028 

3-1667 

3-4306 

3-6944 

3-9583 

20 

2.2222 

2.3611 

2.5000 

2.7778 

3-0556 

3-3333 

3-6III 

3.8889 

4.1667 

21 

2.3333 

2.4792 

2.6250 

2-9167 

3-2083 

3-SOOO 

3-7917 

4-0833 

4-3750 

22 

2.4444 

2.5972 

2.7500 

3-0556 

3-3611 

3.6667 

3-9722 

4-2778 

4-5833 

23 

2.5556 

2.7153 

2.8750 

3-1944 

3-5139 

3-8333 

4-1528 

4.4722 

4-7917 

24 

2.6667 

2.8333 

3.0000 

3-3333 

3-6667 

4.0000 

4-3333 

4.6667 

5.0000 

25 

2.7778 

2.9514 

3-1250 

3-4722 

3.8194 

4.1667 

4-5139 

4.8611 

5.2083 

26 

2.8889 

3.0694 

3-2500 

3-6111 

3.9722 

4-3333 

4-6944 

5-0555 

5-4167 

27 

3.0000 

3.187s 

3-3750 

3-7SOO 

4-1250 

4-5000 

4-8750 

5-2500 

56250 

28 

3-IIII 

33056 

3.5000 

3-8889 

4.2778 

4.6667 

S-0556 

5-4444 

5-8333 

29 

3.2222 

3.4236 

3-6250 

4.0278 

4-4306 

4-8333 

5.2361 

5-6389 

6-0417 

30 

3.3333 

3.5417 

3-7500 

4.1667 

4-5833 

5.0000 

5-4167 

5.8333 

6.2500 

INTEREST  TABLES 
Table   i  (continued) 


485 


Interest  on  Si, 000 


I  Month,  I  Day  to  2  Months 


Days 

4% 

4  1/4% 

4  1/2% 

5% 

5  I  '2% 

6% 

6  1/2% 

7% 

7  1/2% 

s 

$ 

S 

S 

5 

$ 

$ 

$ 

$ 

I 

3-4444 

3-6597 

3-8750 

4-3056 

4.7361 

5.1667 

5-5972 

6.0278 

6.4583 

2 

3-5556 

3-7778 

4.0000 

4-444.J 

4.8889 

5.3333 

5-7778 

6.2222 

6.6667 

3 

3-6667 

3-8958 

4-1250 

4.5833 

5.0417 

5-5000 

5.9583 

6.4167 

6.8750 

4 

3.7778 

4-0139 

4.2500 

4.7222 

5.1944 

5-6667 

6.1389 

6.6111 

7.0833 

S 

3-8889 

4-1319 

4-3750 

4.8611 

S.3472 

5-8333 

6.3194 

6.8055 

7.2917 

6 

4.0000 

4-2500 

4.5000 

5.0000 

S.5000 

6.0000 

6.5000 

7.0000 

7.5000 

7 

4.1 1 1 1 

4-3681 

4-6250 

5.1389 

5.6528 

6.1667 

6.6806 

7-1044 

7.7083 

8 

4.2222 

4.J861 

4-7500 

5-2778 

5.8056 

6.3333 

6.8611 

7-3889 

7.9167 

9 

4-3333 

4.6042 

4-8750 

5-4167 

5.9583 

6.5000 

7.0417 

7-5833 

8.1250 

10 

4.4444 

4.7222 

S.OOOO 

5-5556 

6. nil 

6.6667 

7.2222 

7-7778 

8.3333 

II 

4-5556 

4.8403 

5.1250 

5.6944 

6.2639 

6.8333 

7.4028 

7-9''22 

8.5417 

12 

4.6667 

4-9583 

5.2500 

5.8333 

6.4167 

7.0000 

7.5833 

8.1666 

8.7500 

13 

4-7778 

5-0764 

5. 3750 

5.9722 

6.5694 

7.1667 

7.7639 

8.361 1 

8.9583 

14 

4.8889 

5-1944 

5-5000 

6.1111 

6.7222 

7-3333 

7-9444 

8.5555 

9.1667 

IS 

S.oooo 

5.3125 

5-6250 

6.250c 

6.8750 

7-5000 

8.1250 

8.7500 

9-3750 

16 

5-1III 

5-4306 

5-7500 

6.3889 

7.0278 

7-6667 

8.3056 

8.9444 

9-S833 

17 

5.2222 

5-5486 

5-8750 

6.5278 

7.1806 

7-8333 

8.4861 

9.1389 

9-7917 

18 

5-3333 

5-6667 

6.ooor 

6.6667 

7-3i3i 

8.0000 

8.6667 

9-3333 

10.0000 

19 

5-444-J 

5.7847 

6.1250 

6.8056 

7.4861 

8.1667 

8.8472 

9.5278 

10.2083 

20 

5-5556 

5.9028 

6.2500 

6.9444 

7.6380 

8.3333 

9.0278 

9.7222 

10.4167 

21 

5-6667 

6.0208 

6.3750 

7.o8.i3 

7.7917 

8.5000 

9.2083 

9.9166 

10.6250 

22 

5.7778 

6.1389 

6.5000 

7.2222 

7.9444 

8.6667 

9.3889 

lO.IIII 

10.8333 

23 

5-8889 

6.2569 

6.6250 

7.3611 

8.0972 

8.8333 

9.5694 

10.3055 

II. 0417 

24 

6.0000 

6.3750 

6.7500 

7.5000 

8.2500 

9. 0000 

9.7500 

I0.5COO 

11.2500 

25 

6. mi 

6.4931 

6.8750 

7.6389 

8.4028 

9.1667 

9.9306 

10.6944 

11-4583 

26 

6.2222 

6.61 1 1 

7.0000 

7.7778 

8.5556 

9.3333 

10. nil 

10.8889 

11-6667 

27 

6.33i.i 

6.7292 

7.1250 

7.9167 

8.7083 

9.5000 

10.2917 

11.0833 

11-8750 

28 

6.4444 

6.8472 

7.2500 

8.0556 

8.8611 

9.6667 

10.4721 

11.2778 

12.0833 

29 

6.5556 

6.9653 

7.3750 

8.1944 

9.0139 

9.8333 

10.6528 

11.4722 

12.2917 

30 

6.6667 

7-0833 

7-5000 

8.3333 

9.1667 

10.0000 

10.8333 

11.6666 

12.5000 

486 


APPENDIX 
Table   i  (continued) 


Interest  on  $  1,000 


2  Months,  I  Day  to  3  Months 


Days 

4% 

4  1/4% 

4  1/2% 

5% 

5  1/2% 

6% 

6  1/2% 

7% 

7  1/2% 

s 

S 

$ 

$ 

$ 

$ 

s 

s 

$ 

I 

6.7778 

7.2014 

7.6250 

8.4722 

9.3194 

10.1667 

I  I.OIZ9 

II.86II 

12.7083 

2 

6.8889 

7.3194 

7.7500 

8.6111 

9.4722 

10.3333 

11.194.- 

12.0556 

12.9167 

3 

7.0000 

7.4375 

7.8750 

8.7500 

9.6250 

10.5000 

11.3750 

12.2500 

13.1250 

4 

7. Ill  I 

7.5556 

8.0000 

8.8889 

9.7778 

10.6667 

11.5556 

12.4444 

13-3333 

5 

7.2222 

7.6736 

8.125c 

9.0278 

9.9306 

10.8333 

II. 7361 

12.6389 

13-5417 

6 

7-3333 

7.7917 

8.2500 

g.1667 

10.0833 

11.0000 

II. 9167 

12.8333 

13-7500 

7 

7.4444 

7.9097 

8.3750 

9.3056 

10.2361 

1 1. 1667 

12.0972 

13.0278 

13-9583 

8 

7.5556 

8.0278 

8.5000 

9.4444 

10.3889 

11.3333 

12.2778 

13.2222 

14.1667 

9 

7.6667 

8.1458 

8.6250 

9.5833 

10.5417 

11.5000 

12.4583 

13.4167 

14-3750 

10 

7.7778 

8.2639 

8.7500 

9.7222 

10.6944 

11.6667 

12.6389 

I3.6III 

14-5833 

1 1 

7.8889 

8.3819 

8.8750 

9.8611 

10.8472 

11.8333 

12.8194 

13.8056 

14.7917 

12 

8.000c 

8.5000 

9.0000 

10.0000 

I  1. 0000 

12.0000 

13.0000 

14.0000 

15.0000 

13 

8. nil 

8.6181 

9-1250 

10.1389 

11.1528 

12.1667 

13.1806 

14.1944 

15.2083 

Id 

8.2222 

8.7361 

9.2500 

10.2778 

11.3056 

12.3333 

I3.36II 

14.3889 

15-4167 

IS 

8.3333 

8.8542 

9.3750 

10.4167 

11.4583 

12.5000 

13.5417 

14.5833 

iS-6250 

16 

8.4444 

8.9722 

9.5000 

10.5556 

II.6III 

12.6667 

13.7222 

14-7778 

lS-8333 

17 

8.5556 

9.0903 

9.6250 

10.69.14 

11.7639 

12.8333 

13.9028 

14.9722 

16.0417 

18 

8.6667 

9.2083 

9.7500 

10.8333 

II. 9167 

13.0000 

14.0833 

15.1667 

16.2500 

19 

8.7778 

9.3264 

9.8750 

10.9722 

12.0694 

13.1667 

14.2639 

I5.36II 

16.4583 

20 

8.8889 

9.4444 

10.0000 

II. nil 

12.2222 

13.3333 

14.4444 

15-5556 

16.6667 

21 

9.0000 

9.5625 

10.1250 

1 1.2500 

12.3750 

13.5000 

14.6250 

15-7500 

16.8750 

22 

9. nil 

9.6806 

10.2500 

11.3889 

12.5278 

13.6667 

14.8056 

15-9444 

17-0833 

23 

9.2222 

9.7986 

10.3750 

11.5278 

12.6806 

13-8333 

14.9861 

16.1389 

17.2917 

24 

9.3333 

9.9167 

10.5000 

11.6667 

12.8333 

I4.C000 

15.1667 

16.3333 

17.5000 

25 

9. 4444 

10.0347 

10.6250 

11.8056 

12.9861 

14.1667 

15.3472 

16.5278 

17.7083 

26 

9.5556 

10.1528 

10.7500 

11.9444 

13.1389 

14.3333 

IS. 5278 

16.7222 

17.9167 

27 

9.6667 

10.2708 

10.8750 

12.0833 

13.2917 

14.5000 

15.7083 

16.9167 

18.1250 

28 

9.7778 

10.3889 

11.0000 

12.2222 

13.4444 

14.6667 

15-8889 

17. nil 

18.3333 

29 

9.8889 

10.5069 

II. 1250 

12.3611 

13-5972 

14-8333 

16.0694 

17.3056 

18.5417 

30 

10.0000 

10.6250 

11.2500 

12.5000 

13.7500 

15.0000 

16.2500 

17.5000 

18.7500 

INTEREST  TABLES 


487 


Table  2 — Interest  Calculated  on  Basis  of  365  Days  to  the  Year 

Interest  on  $i,ooo  i  Day  to  31  Days 


Days 

4% 

4  1/4% 

4  1/2% 

5% 

S  1/2% 

6% 

6  1/2% 

7% 

7  1/2% 

s 

$ 

$ 

$ 

S 

S 

$ 

s 

$ 

I 

0.1096 

O.1164 

0.1233 

0-1370 

0.1507 

0.1644 

0.1781 

0.1918 

0-2055 

2 

0.2192 

0.2329 

0.2466 

0.2740 

0.3014 

0.3288 

0.3562 

0.3836 

O-4110 

3 

0.3288 

0-3493 

0.3699 

0.4110 

0.4521 

0.4932 

0.5342 

O.S753 

0.6164 

4 

0.4384 

0-4658 

0.4932 

0.5479 

0.6027 

0.6575 

0.7123 

0.7671 

0.8219 

S 

0.5479 

0-5822 

0.6164 

0-6849 

0.7534 

0.8219 

0.8904 

0.9589 

1-0274 

6 

o.6';75 

0.6986 

0.7397 

0.8219 

0.9041 

0.9863 

1-0685 

1-IS07 

1-2329 

7 

0.7671 

0.81SI 

0.8630 

0.9589 

1-0548 

1.1507 

1.2466 

1-3425 

1-4384 

8 

0.8767 

0.93 1 5 

0.9863 

I-0959 

1.2055 

1-3151 

1.4247 

1-5342 

1-6438 

9 

0.9863 

1.0479 

1. 1096 

1-2329 

1-3562 

1-4795 

1.6027 

I-7260 

1.8493 

10 

1-0959 

1. 1644 

1.2329 

1-3699 

1.S068 

1-6438 

1.7808 

1-9178 

2.0548 

II 

1.2055 

1.2808 

1.3562 

1-5068 

1-6575 

1.8C82 

1.9589 

2.1096 

2.2603 

12 

1-3151 

1-3973 

1-4795 

1.6438 

1.8082 

1.9726 

2.1370 

2-3014 

2.4658 

13 

1.4247 

I-S137 

1.6027 

1.7808 

1.9589 

2.1370 

2.3151 

2-4932 

2.6712 

14 

1-5342 

I-6301 

1.7260 

1. 9178 

2.1096 

2.301J 

2.4931 

2.6849 

2.8767 

15 

1.6438. 

1.7466 

1-8493 

2.0548 

2.2603 

2.4658 

2.6712 

2.8767 

3.0822 

16 

1-7534 

1.8630 

1.9726 

2.1918 

2.J1 10 

2.6301 

2.8493 

3-0685 

3-2877 

17 

X-8630 

1-9795 

2-0950 

2.3288 

2.5616 

2.7945 

3-0274 

3-2603 

3-4931 

18 

1.9726 

2-0959 

2.2192 

2.4658 

2.7123 

2.9589 

3-2055 

3-4521 

3-6986 

19 

2.0822 

2.2123 

2-3425 

2.6027 

2-8630 

3-1233 

3-3836 

3-6438 

3.9041 

20 

2-1918 

2.3288 

2.4658 

2.7397 

3-0137 

3-2877 

3.5616 

3-8356 

4-1096 

21 

2.3014 

2-4452 

2.5890 

2,8767 

3-1644 

3-4521 

3-7397 

4.C274 

4-31SI 

22 

2.4110 

2.5616 

2.7123 

3.0137 

3-3151 

3-6164 

3-9178 

4.2192 

4-5205 

23 

2.5205 

2.6781 

2.8356 

3.1507 

3-4658 

3-7808 

4-0959 

4.4110 

4.7260 

24 

2.6301 

2-7945 

2.9589 

3.2877 

3-6164 

3-9452 

4.2740 

4.6027 

4-9315 

25 

2.7397 

2.9110 

3.0822 

3.4247 

3-7671 

4.1096 

4-4521 

4-7945 

5-1370 

26 

2.8493 

3-0274 

3-2055 

3.5616 

3-9178 

4.2740 

4-6301 

4-9863 

5-3425 

27 

2.9589 

3-1438 

3.3288 

3.6986 

4-0685 

4.4384 

4-8082 

5-1781 

5-5479 

28 

3.0685 

3-2603 

3.4521 

3.8356 

4-2192 

4.6027 

4-9863 

5-3699 

5-7534 

29 

3-1781 

3-3767 

3-5753 

3-9726 

4-3699 

4.7671 

S-1644 

5-5616 

S-9589 

30 

3-2877 

3-4931 

3-6986 

4.1096 

4-5205 

4-9315 

S-3425 

5-7534 

6.1644 

31 

3-3973 

3-6096 

3-8219 

4.2466 

4-6712 

5 -0959 

5-5205 

5-9452 

6.3699 

488 


Interest  on  Jl.ooo 


APPENDIX 
Table  2  (continued) 


32  Days  to  62  Days 


Days 

4% 

4  I  '4% 

4  1/2% 

5% 

5  1/2% 

6% 

6  1/2% 

7% 

7  1/2% 

$ 

$ 

$ 

$ 

S 

s 

S 

$ 

s 

32 

3.S068 

3-7260 

3-9452 

4.3836 

4.8219 

5-2603 

5.6986 

6.1370 

6.5753 

33 

3.6164 

3-8425 

4.0685 

4.5205 

4.9726 

5-4247 

5-8767 

6.3288 

6.7808 

34 

3.7260 

3-9589 

4.1918 

4.6575 

S-1233 

5-5890 

6.0548 

6.520s 

6.9863 

35 

3.8356 

4-0753 

4-3151 

4-7945 

5-2740 

5-7534 

6.2329 

6.7123 

7.1918 

36 

3-9452 

4.1918 

4-4384 

4-9315 

5-4247 

5-9178 

6.4110 

6.9041 

7-3973 

37 

4.0548 

4-3082 

4-5616 

5-0685 

5-5753 

6.0822 

6.5890 

7-0959 

7.6027 

38 

4.1644 

4.424- 

4.6849 

5-2055 

5-7260 

6.2466 

6.7671 

7.2877 

7.8082 

39 

4.2740 

4-5411 

4.8082 

5-3425 

5.8767 

6.41  ID 

6.9452 

7-4795 

8.0137 

40 

4-3836 

4-6575 

4-9315 

5.4795 

6.0274 

6.5753 

7.1233 

7-6712 

8.2192 

Al 

4-4932 

4.7740 

5-0548 

5.6164 

6.1781 

6.7397 

7-3014 

7-8630 

8.4247 

42 

.'.6027 

4.8904 

5-1781 

5-7534 

6.3288 

6.9041 

7-4794 

8.0548 

8.6301 

43 

4-7123 

5.0068 

5-3014 

5.8904 

6-4795 

7-0685 

7.6575 

8.2466 

8.8356 

44 

4.8219 

5-1233 

S-4247 

6.0574 

6.6301 

7-2329 

7-8356 

8.4384 

9.041 1 

45 

4-9315 

5-2397 

5-5479 

6.1644 

6.7808 

7-3973 

8.0137 

8.6301 

9.2466 

46 

5-04II 

5-3562 

5-6712 

6.3C14 

6.9315 

7-5616 

8.1918 

8.8219 

9-4521 

47 

S-1507 

5-4726 

5-7945 

6.4384 

7.0822 

7.7260 

8.3699 

9-0137 

9-6575 

48 

5-2603 

5-5890 

5-9178 

6.5753 

7-2329 

7.8904 

8.54-9 

9-2055 

9-8630 

49 

5-3609 

5-7055 

6.0411 

6.7123 

7-3836 

8.0548 

8.7260 

9-3973 

10.0685 

SO 

5-4795 

5-8219 

6-1644 

6.8493 

7-5342 

8.2192 

8.9041 

9-5890 

10-2740 

51 

5-5890 

5-9384 

6.2877 

6-9863 

7.6849 

8.3836 

9.0822 

9.7808 

10.4794 

52 

5-6986 

6.0548 

6.4110 

7-1233 

7-8356 

8.5479 

9.2603 

9.9726 

10.6849 

53 

5. 8082 

(?.I7I2 

6.5342 

7.2603 

7-9863 

8.7123 

9.4384 

10.1644 

10.8904 

54 

5-9178 

6-2877 

6.6575 

7.3973 

8.1370 

8.8767 

9.6164 

10.3562 

11.0959 

55 

6-0274 

6.4041 

6.7808 

7-5342 

8.2877 

9.0411 

9.794s 

10.5479 

II. 3014 

56 

6-1370 

6.52C5 

6.9041 

7-6712 

84384 

9-2055 

9.9726 

10.7397 

11.5068 

57 

6.2466 

6.6370 

7.0274 

7.8082 

8.5890 

9.3699 

10.1507 

10.9315 

II. 7123 

58 

6.3562 

6-7534 

7.1507 

7.9452 

8.7397 

9-5342 

10.3288 

II. 1233 

11.9178 

59 

6.4658 

6.8699 

7.2740 

8.0822 

8.8904 

9.6986 

10.5068 

11.3151 

12.1233 

60 

6-5753 

6.9863 

7-3973 

8.2192 

9.041 1 

9.8630 

10.6849 

11.5068 

12.3288 

6r 

6.6849 

7.1027 

7-5205 

8.3562 

9.1918 

10.0274 

10.8630 

11.6986 

12.5342 

62 

6-7945 

7.2192 

7-6438 

8.4932 

9-3425 

10.1918 

1 1. 04 1 1 

11.8904 

12.7397 

LNTEREST  TABLES 
Table  2  (continued) 


489 


Interest  on  $  1,000 


63  Days  to  93  Days 


Days 

4% 

4  I  '4% 

A  I  '2% 

5% 

5  1/2% 

6% 

6  1,2% 

7% 

7  1/2% 

s 

$ 

$ 

s 

$ 

S 

$ 

s 

$ 

63 

6.9041 

7-3356 

7.7671 

8.6301 

9-4932 

10.3562 

II. 2192 

12.0822 

12.9452 

6s 

7-0137 

7-4521 

7.8904 

8.7671 

9-6438 

10.5205 

11-3973 

12.2740 

13.1507 

65 

7-1233 

7-568S 

8.0137 

8.9041 

9-7945 

10.6849 

11-5753 

12.4658 

13-3562 

66 

7-2320 

7.6849 

8.1370 

9.04II 

9-9452 

10.8493 

11-7534 

12. 6575 

13-5616 

67 

7-3425 

7.8014 

8.2603 

9.I78I 

10.0959 

II. 0137 

1 1-93 1 5 

12.8493 

13-7671 

68 

7-4521 

7.9178 

8.3836 

9-3ISI 

10.2466 

11.1781 

12.1096 

13.041 1 

13.9726 

69 

7-5616 

8.0342 

8.5068 

9-4521 

10.3973 

11-3425 

12.2877 

13-2329 

14.1781 

70 

7.6712 

8.1507 

8.6301 

9-5890 

10.5479 

11.5068 

12.4657 

13.4247 

14-3836 

71 

7-7808 

8.2671 

8.7534 

9-7260 

10.6986 

II. 6712 

12.6438 

13.6164 

14-5890 

72 

7-8904 

8-3836 

8.8767 

9.8630 

10.8493 

11.8356 

12.8219 

13.8082 

14-7945 

73 

8-0000 

8.5000 

9.0C00 

10.0000 

1 1. 0000 

12.0000 

13.0000 

14.0000 

15.0000 

74 

8.1096 

8.6164 

9-1233 

10.1370 

11.1507 

12.1644 

13-I781 

14.1918 

15-2055 

75 

8.2192 

8.7329 

9.2466 

10.2740 

1I-3014 

12.3288 

13-3562 

14-3836 

15.4110 

76 

8.3288 

8.8493 

9-3699 

10.4110 

11-4521 

12.4932 

13-5342 

14-5753 

15.6164 

77 

8.4384 

8-9657 

9-4932 

10.5479 

1 1-6027 

12.6575 

13-7123 

14-7671 

15-8219 

78 

8.5479 

9.0822 

9.6164 

10.6849 

11-7534 

12.8219 

13-8904 

14.9589 

16-0274 

79 

8.6575 

9.1986 

9-7397 

10.8219 

II. 904 1 

12.9863 

14.0685 

15-1507 

16.2329 

80 

8.7671 

9.31SI 

9.8630 

10.9589 

12.0548 

13-1507 

14.2466 

15-3425 

16.4384 

81 

8.8767 

9.431S 

9.9863 

11-0959 

12.2055 

13-3151 

14-4247 

15-5342 

16.6438 

82 

8.9863 

9-5479 

10.1096 

11-2329 

12-3562 

13-4795 

14.6027 

15.7260 

16.8493 

83 

9-0959 

9-6644 

10.2329 

11-3699 

12.5068 

13.6438 

14.7808 

15-9178 

17.0548 

84 

9.2055 

9.7808 

10.3562 

1 1.5068 

12.6575 

13.8082 

14-9589 

16-1096 

17.2603 

85 

9-3151 

9-8973 

10.4795 

11.6438 

12.8082 

13.9726 

15-1370 

16.3014 

17-4657 

86 

9.4247 

10.0137 

10.6027 

11.7808 

12.9589 

14.1370 

15-3151 

16.4932 

17.6712 

87 

9-5342 

10.1301 

10.7260 

1 1. 9178 

13.1096 

14-3014 

15-4931 

16.6849 

17.8767 

88 

9-6438 

10.2466 

10.8493 

12.0548 

13.2603 

14-4658 

15-6712 

16.8767 

18.0822 

89 

9-7534 

10.3630 

10.9726 

12.1918 

13.4110 

14.6301 

15-8493 

17.0685 

18.2877 

90 

9-8630 

10.4794 

11.0959 

12.3288 

13-5616 

14-7945 

16.0274 

17.2603 

18.4931 

91 

9-9726 

10.5959 

II. 2192 

12.4658 

13-7123 

14.9589 

16.2055 

17-4521 

18.6986 

92 

IO-0822 

10.7123 

11.342s 

12.6027 

13-8630 

15-1233 

16.3836 

17-6438 

18-904  I 

93 

10.1918 

10.8288 

11.4658 

12.7397 

14-0137 

15.2877 

16.5616 

17-8356 

19.1096 

490 


APPENDIX 


Table  3 — Amount  of  $i  for  Any  Time  from  i  to  45  Periods 

Interest  compounded  annually  45  years;  semiannually  22K  years;  and 
quarterly  for  ii}4  years 


Periods 

2% 

2  1/2% 

3% 

3  1/2% 

4% 

I 

1.020  000 

1. 025  000 

1.030  000 

1.035  000 

1.040  000 

2 

i.oao  400 

1.050  625 

1. 06c  900 

1. 071  225 

1. 08 1  600 

3 

1. 061  208 

1.076  891 

1.092  727 

1. 108  718 

1. 1 24  864 

4 

1.082  432 

1. 103  813 

1. 125  509 

1. 147  523 

1. 169  859 

5 

1. 104  081 

1. 131  408 

1. 159  274 

1. 187  686 

1. 216  653 

6 

1. 126  162 

II59  693 

1. 194  052 

1.229  255 

1.265  319 

7 

1. 148  686 

1. 188  686 

1.229  874 

1.272  279 

1. 315  932 

8 

1. 171  659 

1.218  403 

1.266  770 

1. 316  809 

1.368  S69 

9 

I.I9S  093 

1.248  863 

1.304  773 

1.362  897 

1.423  312 

10 

1. 218  994 

1.280  085 

1-343  916 

1. 410  599 

1.480  244 

II 

1.243  374 

1. 312  087 

1.384  234 

1.459  970 

1.539  454 

12 

1.268  242 

1.344  889 

1.42s  761 

1.5 1 1  069 

1. 601  032 

13 

1.293  607 

1.378  511 

1.468  534 

1-563  956 

1.665  074 

14 

1. 319  479 

1-412  974 

I-S12  590 

1. 618  695 

1.731  676 

15 

1. 345  868 

1.448  298 

1-557  967 

1-675  349 

1.800  944 

16 

1.372  786 

1.484  506 

1.604  706 

1-733  986 

1-872  981 

17 

1.400  241 

I-521  618 

1.652  848 

1.794  676 

1.947  901 

18 

1.428  246 

1.559  659 

1.702  433 

1. 857  489 

2-02S  817 

19 

1.456  811 

1.598  650 

1.753  506 

1.922  501 

2.106  849 

20 

1.485  947 

t.638  616 

1.806  III 

1.989  789 

2. 191  123 

21 

1.515  666 

1.679  582 

1.860  29s 

2.059  432 

2.278  768 

22 

1.545  980 

1. 721  571 

1. 916  103 

2. 131  512 

2.369  919 

23 

1.576  899 

1.764  611 

1.973  587 

2.206  115 

2.464  716 

24 

1.608  437 

1.808  726 

2.032  794 

2.283  329 

2.563  304 

25 

1.640  606 

I-8S3  944 

2.093  778 

2.363  245 

2.665  836 

26 

1.673  418 

•  1.900  293 

2.156  59t 

2.44s  959 

2.772  470 

27 

1.706  887 

1. 9-17  800 

2.221  289 

2.531  567 

2.883  369 

28 

1. 741  024 

1.996  495 

2.287  928 

2.620  172 

2.998  703 

29 

1. 775  84s 

2.046  407 

2.356  566 

2. 711  878 

3-II8  652 

30 

X.811  362 

2.097  568 

2.427  263 

2.806  794 

3.243  398 

31 

1.847  589 

2.150  007 

2.500  080 

2.905  032 

3-373  133 

32 

1.884  541 

2.203  757 

2.575  083 

3.006  708 

3-508  059 

3i 

1.922  231 

2.258  851 

2.652  335 

3. Ill  942 

3-648  381 

34 

1.960  676 

2.315  322 

2.731  905 

3.220  860 

3-794  316 

35 

1.999  890 

2.373  205 

2.813  863 

3.333  590 

3-946  089 

36 

2.039  887 

2.432  535 

2.898  278 

3.450  266 

4-103  933 

37 

2.080  685 

2.493  349 

2.985  227 

3.571  025 

4.268  090 

38 

2.122  299 

2.555  682 

3.074  784 

3.696  oil 

4-438  814 

39 

2.164  745 

2.619  575 

3.167  027 

3.82s  372 

4-616  366 

40 

2.208  040 

2.685  064 

3.262  038 

3.959  260 

4.801  021 

41 

2.252  201 

2.752  190 

3-359  899 

4.097  834 

4-993  062 

42 

2.297  245 

2.820  995 

3.460  696 

4.241  258 

5.192  784 

43 

2.343  189 

2.891  520 

3.564  517 

4.389  7C2 

5. 400  495 

44 

2.390  OS3 

2.963  808 

3.671  452 

4-543  342 

5. 616  SIS 

45 

2-437  854 

3-037  903 

3.781  596 

4.702  359 

5.841  176 

INTEREST  TABLES 


491 


Table  4 — Present  Worth  of  I i  Due  at  Any  Time  from  i  to  45  Periods 

Interest  compounded  annually  45  years;  semiannually  for  2  2>^  years; 
and  quarterly  for  ii/<4  years 


Periods 

2% 

2  I  2% 

3% 

3  1/2% 

4% 

I 

980392157 

975609756 

970873786 

966183575 

961538462 

2 

961168781 

951814396 

942595909 

933510700 

924556213 

3 

942322335 

92859941 1 

915141659 

901942706 

888996359 

4 

923845426 

905950645 

888487048 

871442228 

854804191 

5 

905730810 

883854288 

862608784 

841973167 

821927107 

6 

887971382 

862296866 

837484257 

813500644 

790314526 

7 

870560179 

841265235 

813091511 

785990961 

759917813 

8 

853490371 

820746571 

789409234 

759411556 

730690205 

9 

836755266 

800728362 

766416732 

733730972 

702586736 

10 

820348300 

781198402 

744093915 

708918814 

675564169 

1 1 

804263039 

762144782 

722421277 

684945714 

649580932 

12 

788493176 

743555885 

701379880 

661783298 

624597050 

13 

773032525 

725420376 

680951340 

639404153 

600574086 

14 

757875025 

707727 196 

661 1 17806 

617781790 

577475083 

15 

743014730 

690465557 

641861947 

596890619 

555264503 

16 

728445814 

673624934 

623166939 

576705912 

533908176 

17 

714162562 

65''i95057 

605016446 

557203779 

513373246 

18 

700159375 

641165909 

587394608 

538361140 

493628121 

19 

686430760 

625527716 

570286027 

520155690 

474642424 

20 

672971333 

610270943 

553675754 

502565884 

456386949 

21 

659775817 

S95386286 

537549276 

485570903 

438833602 

22 

646839036 

580864669 

521892501 

4691 5063 1 

421955387 

23 

634155918 

566697238 

506691748 

453285634 

405726333 

24 

621721488 

552875354 

491933736 

437957134 

390121474 

25 

609530871 

539390589 

477605569 

423146989 

375116802 

26 

5975-9285 

S26234721 

463694727 

408837671 

360689233 

27 

585862044 

513399728 

450189056 

395012242 

346816570 

28 

574374553 

500877784 

43-076753 

381654340 

333477471 

29 

563 1 1 2307 

488661252 

424346362 

368748155 

320651415 

3C 

552070889 

476742685 

41 1986760 

356278411 

308318668 

31 

541245970 

465114815 

399987145 

344230348 

296460258 

32 

530633304 

453770551 

388337034 

332589709 

285057940 

33 

520228729 

442702977 

3770262J7 

321342714 

274094173 

34 

510028166 

431905343 

366044900 

310476052 

263552090 

35 

500027613 

421371066 

355383398 

299976862 

253415471 

36 

490223150 

411093723 

345032425 

289832717 

243668722 

37 

480610932 

401067047 

334982937 

28003161O 

234296848 

38 

471187188 

391284924 

325226152 

270561942 

225285431 

39 

461948223 

381741389 

315753546 

261412505 

216620606 

40 

452890415 

372430624 

306556841 

252572468 

208289045 

41 

444010211 

363346950 

297628001 

244031370 

200277928 

42 

435304128 

35J484829 

288959224 

235779102 

192574930 

43 

426768753 

3458388S8 

280542936 

227805895 

185168202 

4J 

418400739 

337403764 

272371782 

22OIO2314 

178046348 

45 

410196803 

329171404 

264438624 

212659241 

171198412 

492 


APPENDIX 


Table  5 — Amount  of  $i  Set  Aside  Each  Period  for  i  to  45  Periods 

Interest  compounded  annually  45  years;  semiannually  22K  years;  and 
quarterly  for  ii}i  years 


Periods 

2% 

2  1/2% 

3% 

3  1/2% 

4% 

I 

1. 000 

000 

1. 000  000 

1. 000 

000 

1. 000 

000 

1. 000  000 

2 

2.020 

000 

2.02s  000 

2.030 

000 

2.C35 

000 

2.040  000 

3 

3.060 

400 

3.075  625 

3-090 

900 

3106 

225 

3. 121  600 

4 

4. 121 

608 

4.152  SI6 

4.183 

627 

4.214 

943 

4.246  464 

5 

5.204 

040 

S-2S6  329 

5.309 

136 

5.362 

466 

5.416  323 

6 

6.308 

121 

6-387  737 

6.468 

410 

6.550 

152 

6.632  976 

7 

7.434 

283 

7-S/17  430 

7.662 

462 

7.779 

4r.8 

7.898  295 

8 

8.582 

969 

8.736  116 

8.892 

336 

9.051 

687 

9.214  226 

9 

9-754 

628 

9-954  519 

10. 159 

106 

10.368 

496 

10.582  795 

10 

10.9.19 

721 

11.203  382 

11.463 

879 

II.73I 

393 

12.006  107 

II 

12.168 

715 

12.483  466 

12.807 

796 

13. 141 

992 

13-486  351 

12 

13.412 

090 

13-795  553 

14.192 

030 

14.601 

962 

15-025  806 

13 

14.680 

332 

15-140  442 

15.617 

790 

16. 113 

030 

16.626  838 

14 

15.973 

938 

16.518  953 

17-086 

324 

17.676 

986 

18.291  911 

IS 

17-293 

417 

17.931  927 

18.598 

914 

19.29s 

681 

20.023  588 

16 

18.639 

285 

19.380  225 

20.156 

881 

20.971 

030 

21.824  531 

17 

20.012 

071 

20.864  730 

21.761 

588 

22.70s 

016 

23.697  512 

18 

21.412 

312 

22.386  349 

23.414 

435 

24.499 

691 

25.645  413 

19 

22.840 

559 

23.946  007 

25.116 

868 

26.357 

181 

27.671  229 

20 

24.297 

370 

25.544  658 

26.870 

375 

28.279 

682 

29.778  079 

21 

25-783 

317 

27.183  274 

28.676 

486 

30.269 

471 

31.969  202 

22 

27.298 

984 

28.862  856 

30.536 

780 

32.328 

902 

34.247  970 

23 

28.844  963 

30.584  427 

32.452 

884 

34.460 

414 

36.617  889 

24 

30.421 

S63 

32.349  038 

34.426 

470 

36.666 

528 

39.082  604 

25 

32.030 

300 

34.157  764 

36.459 

264 

38.949 

857 

41.64s  908 

26 

33-6-0 

gr6 

36.011  708 

38.553 

042 

41.313 

102 

44-311  7JS 

27 

35-344 

324 

37-912  001 

40.709 

634 

43.759 

060 

47.084  214 

28 

37-051 

210 

39-859  801 

42.930 

923 

46.290 

627 

49.967  583 

20 

38-792 

235 

41.856  296 

45.218 

850 

48.910 

800 

52.966  286 

30 

40.568 

079 

^13.902  703 

47.575 

416 

51.622 

677 

56.084  938 

31 

42.379 

441 

46.000  271 

50.002 

678 

54.429 

471 

59.328  335 

32 

4/>.227 

030 

48.150  278 

52.502 

759 

57.334 

503 

62.701  469 

33 

46.  II I 

S70 

50.354  C34 

55.077 

841 

60.341 

210 

66.209  527 

34 

48.033 

802 

52.612  885 

57-730 

177 

63.453 

152 

69.857  909 

35 

49.994 

478 

S4.928  207 

60.462 

082 

66.674 

013 

73.652  225 

36 

51.994 

367 

57-301  413 

63.275 

944 

70.007 

603 

77.598  314 

37 

54.034 

255 

59.733  948 

66.174 

223 

73.457 

869 

81.702  246 

38 

56.114 

940 

62.227  297 

69.159 

449 

77-028 

895 

85.970  336 

39 

58.237 

238 

64.782  979 

72.234 

233 

80.724 

906 

90.409  150 

40 

60.401 

983 

67.402  554 

75.401 

260 

84-550 

278 

95.02s  516 

41 

62.610 

023 

70.087  617 

78.663 

298 

88.509 

538 

99-826  536 

42 

64.862 

223 

72.839  808 

82.023 

197 

92.607 

371 

104.819  598 

43 

67-159 

468 

75.660  803 

85.483 

892 

96.848 

629 

II0.0I2  382 

44 

69-502 

657 

78.552  323 

89.048 

409 

101.238 

331 

IIS.4I2  877 

45 

71.892 

710 

81.516  131 

92.719 

861 

105.781 

673 

121.029  392 

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APPENDIX  E 
ALPHABETICAL  LIST  OF  REFERENCES 

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Receipts  as  Collateral.     1920.    24  pp. 
Anderson,  Jr.,  B.  M.     The  Value  of  Money.     New  York,  The  Macmillan 

Co.,  1917.     610  pp. 
Brady,  J.  E.     Law  of  Bank  Checks.     New  York,  Banking  Law  Journal, 

1915.     463  pp. 
Brown,  H.   G.     International  Trade  and  Exchange.     New  York,  The 

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Chamber  of  Commerce  of  the  United  States.     Trade  Acceptances,  Sup- 
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Commercial  Paper  and  Bills  of  Exchange  of  the  World.     New  York, 

Banking  Law  Journal,  1915.     70  pp. 
Conant,  C.  A.     Principles  of  Money  and  Banking.    New  York,  Harper  & 

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Conway,  T.  Jr.,  and  Patterson,  E.  M.     Operation  of  the  New  Bank  Act. 

Philadelphia,  J.  B.  Lippincott  &  Co.,  1914.     431  pp. 
Davenport,  H.  J.    Economics  of  Enterprise.    New  York,  The  Macmillan 

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Dunbar,  C.  F.     Theory  and  History  of  Banking.     3d  Ed.     New  York, 

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496 


ALPHABETICAL  LIST  OF  REFERENCES  497 

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New  York,  The  Macmillan  Co.,  1913.     501  pp. 
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Johnson,  E.  R.,  and  Huebner,  G.  G.     Railroad  Traffic  and  Rates.    New 

York,  D.  Appleton  &  Co.,  191 1.     2  vol. 
Johnson,  J.  F.    Money  and  Currency.    New  Ed.    Boston,  Ginn  &  Co., 

1921.  425  pp. 

Kemmerer,  E.  W.      A  B  C  of  the  Federal  Reserve   System.     4th   Ed. 

Princeton  University  Press,  1920.    208  pp. 
Money  and  Credit  Instruments  in  Their  Relation  to  General  Prices. 

New  York,  Henry  Holt  &  Co.,  1909.     160  pp. 
Kinley,  D.     Money.    New  York,  The  Macmillan  Co.,  1904. 
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5th  Ed.    New  York,  The  Macmillan  Co.,  1920.     549  pp. 
Kniffin,  W.  H.     Business  Man  and  His  Bank.    New  York,  McGraw-Hill 

Book  Co.,  1920.    278  pp. 


498  APPENDIX 

Kniffin,  W.  H.,  Commercial  Paper,  Acceptances  and  the  Analysis  of 
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Practical  Work  of  a  Bank.     New  York,  Bankers  Publishing  Co., 

1919.    604  pp. 

Savings  Bank  and  Its  Practical  Work.  New  York,  Bankers  Publish- 
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Sons,  1903.      550  PP- 

McMaster,  J.  S.  McMaster's  Irregular  and  Regular  Commercial  Paper. 
New  York,  McMaster  Co.,  1903. 

Margraff,  A.  W.  International  Exchange.  4th  Ed.  New  York,  Anthony 
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Mathewson,  P.  Acceptances,  Trade  and  Bankers.  New  York,  D.  Apple- 
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Meeker,  E.  J.  Work  of  the  Stock  Exchange.  New  York,  Ronald  Press 
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Monetary  Commission  of  the  Indianapolis  Convention.  Report  1898. 
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Moore,  W.  U.  Law  of  Commercial  Paper.  New  York,  D.  Appleton  & 
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Moulton,  H.  G.  Financial  Organization  of  Society.  Chicago,  Uni- 
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Principles  of  Money  and  Banking.    Chicago,  University  of  Chicago 

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Muhleman,  M.  L.  Monetary  and  Banking  Systems.  New  York,  Mone- 
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National  City  Bank  of  New  York.  National  Banking  Under  the  Federal 
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Practical  Bank  Operation.    Prepared  by  L.  H.  Langston.    New  York, 

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O'Mally,  F.  Our  South  American  Trade  and  Its  Financing.  New  York, 
National  City  Bank,  1920.     125  pp. 

Paton,  W.  A.,  and  Stevenson,  R.  A.  Principles  of  Accounting.  New 
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Phillips,  C.  A.  Bank  Credit.  New  York,  The  Macmillan  Co.,  1920. 
374  pp. 


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182  pp. 


INDEX 


Acceptances, 
bank, 

abuses  of,  364 

authorized  by  Federal  Reserve 

Act,  314 
diagrammatic    illustration,  359- 

distinguished    from    commercial 

paper,  55 
form  of,  39 
purchases    by     federal     reserve 

banks,  343 
typical  illustrations,  357 
compared  with  single-name  paper, 

186 
development  of,  305 
entries  on  balance  sheet,  135-136 
shown  in  credit  statement,  241,  246 
trade,  38 

advantages  of,  366 
objections  to,  367 
typical  illustration,  365 
Accommodation  paper,  48,  187 
Accounts, 

adjustment  in  bank  statement,  132 
payable,  245 
receivable,  217,  234-237 
basis  for  loans,  192 
Agricultural  credit,  114-116 
Agricultural     paper,    55     (See    also 
"Cattle loans " ;  " Cotton  loans ' ' ; 
"Grain  bills") 
Aldrich-Vreeland  law,  307 
Analysis  ratios  in  credit  statement, 

220-230 
Arbitrage  in  foreign  exchange,  406 
Authority  to  purchase,  75 

B 

Bailee  receipt,  69 
Balance  sheet, 

federal  reserve  bank,  352-356 

national  bank,  126-140 

significance  of,  in  credit  statement, 
211 


Bank  acceptances  (See  "Acceptances, 

bank") 
Bank  credit,  166 

Bank  notes  (vSee  also  "Federal  re- 
serve bank  notes";  "Federal 
reserve  notes";  "National  bank 
notes") 

advertising,  benefit  of,  165 

compared   with   deposit  currency, 
164 

entries  on  the  balance  sheet,  136 

inelasticity  of,  168,  301,  323 

nature  of,  164 

security  of,  165 
Bank  of  England,  316 
Bank  postal  remittance,  50 
Bank  statement, 

effect  of  operations  on,  126-136 

illustrated,  137-140 
Banking, 

commercial,  98-100 

early  history  of,  94 

investment,  100 

private,  100 
Banking  house,  investment  in,  268 
Banks     (See   also    "Federal    reserve 
banks";    "National    banks"; 
"Savings  banks";  etc.) 

branch,  1 1 1 

charter  authority,  98,  123 

classification,  of  96 

according  to  capital,  143 

definition  of,  95 

early  examples  of,  95 

number  of ,  109-111 

organization  of,  122 
Bars,  bullion,  17 

Bills  of  exchange  (See  also  "Foreign 
exchange") 

acceptance  of,  89 

classes  of,  37,  374 

definition  of,  34 

form  of,  35 

parties  to,  36 

presentment  of,  90 

uses  of,  38-41 
Bills  of  lading, 

export,  59 


501 


502 


INDEX 


Bill  of  lading — Continued 

form  ot,  6i 

negotiability  of,  62 

ocean,  59 

straight  and  order,  58 

through,  60 

transactions    illustrating    use    of, 
60-62 
Bills  payable,  242-245 
Bills  receivable,  191,  232 
Bimetallism  in  U.  S.,  431-433 
Bland  Act,  22,  432 
Blank  indorsement,  84 
Bonded  indebtedness  in  credit  state- 
ment, 249 
Bonds, 

held  by  banks,  263 

pledged  for  national  bank  notes, 
169 
Branch  banks,  11 1 
Building  and  loan  associations,  116 


Call  loans,  176-179 
Call  money,  420-426 
Capital,  bank,  142-144 
comparison  with, 

deposits,  155,  205 

loans,  205 

manufactures  and  railroads,  148 

surplus    and    undivided    profits, 

147 

federal  reserve  banks,  311 

national  banks,  104 

state  banks,  144 
Cash, 

credit  statement,  in,  231 

reserve,  not  counted  as,  274 
Cashier's  check,  46 
Cattle  loans,  194 
Certificates, 

clearing-house,  291 

deposit,  53 

gold,  9,  25 

silver,  10,  25 
Certified  check,  45 
Checks  (See  also  "Indorsements") 

cashier's,  46 

certified,  45 

drawing  of,  42 

example  of  old,  42 

form  of,  41 

presentation  of,  43 

responsibility  of  parties,  44 

stale,  44 


Checks — Continued 

stop-payment  of,  46 

volume  settled  at  clearing  house, 
291 
Checking  accounts,  cost,  158 
Circular  notes,  51 

Circulation  (See  also  "Bank  notes"; 
"Federal  reserve  notes") 

federal  reserve  bank,  325 

national  bank,  inelastic,  168,  301, 

323 

per  capita,  14 

tables  of,  29-30 
Clean  bills  of  exchange,  391 
Clearing  house,  289-299 

certificates,  291 

exchanges,  134 

significance  of  figures,  298 
Coinage, 

charges,  16 

gold,  14 
Coins, 

foreign,  value  of,  493-495 

gold,  14-18 

minor,  24 

silver  dollars,  22 

subsidiary  silver,  24 
Collateral  loan  agreement,  189 
Collateral  loans.  1 88-191 
Commercial  credit  instruments,  34 
Commercial  paper,  54 

buying,  principles  for,  199-202 

fixed  assets,  not  used  for  financing, 
244 

rediscounts     by     federal     reserve 
banks,  338 
Commercial  paper  broker,  202 
Commodity  paper,  55 
Comptroller  of  the  Currency,  super- 
vision over  national  banks,  123 
Conditional  indorsement,  86 
Contingent  liabilities  in  credit  state- 
ment, 249 
Co-operative  banks,  116 
Cotton  loans,  195 

Country  banks,  reserve  of,  272-275 
Credit, 

nature  of,  3-6 

relation  to, 

bank  notes,  166 
money,  i 
price,  6,  442 
Credit  instruments, 

commercial,  34 

exchange  medium,  5 

volume  of,  56 


INDEX 


503 


Credit  statement,  208-218  (See  also 
"Accounts  receivable";  "Bills 
payable";  "Bills  receivable") 

audited  statement,  212 

form  of,  213 

illustrations  of,  255-262 

merchandise.  237-241 

ratios  in  analysis  of,  220-230 
Credit  unions,  117 
Crime  of  1873,  432 
Current  assets,  221 
Current  liabilities,  221 


Demand  loans,  176-178 
Deposit, 

certificate  of,  53 

currency,  153-155 

compared  with  bank  notes,  164 
Deposits, 

charges  made  for  small  accounts, 

159 
guaranty  of,  1 61-163 
interest  on, 
bank, 160 
individual,  159 
relation  to, 

capital,  155,  205 
loans,  150-153,  205 
reserve,  276-291 
savings,  157 
source  of,  150 
time  and  demand,  156-157 
Discount  calculations,  181-185 
Discount  companies,  1 19-122 
Discount  market,  use  cf  bank  accept- 
ances, 362 
Documentary  bills,  391 
Dollar  exchange,  376-397 
Domestic  exchange,  294 
Double-name  paper,  47 
Drafts  (See  "Bills of  exchange") 


Earnings  of  federal  reserve  banks,  350 

Elevator  paper,  55 

Equation  of  exchange,  446-448 


Failures,  causes  of,  208 

Federal  Farm  Loan  Act,  115 

Federal  land  banks,  114 

Federal  Reserve  Act,  passage  of,  308 


Federal  reserve  bank  notes,   10,  27, 

326 
Federal  reserve  banks,  105 

balance  sheet,  352-356 

capital,  311 

clearing-house  settlements,  292 

discount  rates,  317 

earnings,  350 

management  of,  312 

rediscounting  by,  333-343 

relation  to  the  government,  329 

reserves,  326 

held  for  member  banks,  318 

statement  of,  353 
Federal  Reserve  Board,  309 
Federal    reserve    collection    system, 

294-297 
Federal  reserve  districts,  309-311 
Federal  reserve  notes,  10,  27 

early  issues,  335 

expansion  due  to  war,  347 

provisions  of  original  act,  344 

volume  of,  345 
Federal  reserve  system, 

complaints  against  it,  335 

development  by  the  war,  336 

early  development,  333 

elasticity  ot  note  issues,  323-326 
Finance  bills,  40,  403 
First  United  States  Bank,  427 
Foreign  coins,  value  of,  495 
Foreign  exchange, 

classification  of  bills,  374-375 

dollar  exchange,  376 

pegging,  380 

principles  of,  370-384 

process  of,  3^5-394 

typical  transactions,  395-408 
Free  gold  and  federal  reserve  banks, 
350 


Gold, 
bars,  17 

certificates,  9-10,  25 
coinage,  14-18 
coins,  foreign,  17 
cubic  contents,  19 
effect  of  export  and  import  on  bank 

credit,  281 
imports  and  exports,  20 
mining,  proposed  subsidy,  21-22 
mint  price,  21 
production,  19-20 
stock,  18-19 


504 


INDEX 


Gold    reserve    and    federal    reserve 

notes,  346 
Gold  settlement  fund,  297 
Gold  Standard  Act  of  1900,  22 
Government  promissory  notes,  428 
Grain  bills,  197-198 
Greenbacks,  9,  25 
Guaranty  of  deposits,  161-163 


H 


Hypothecation,  190 
certificate,  69-70 

I 

Income  sheet,  251-252 
Index  numbers,  434-435 
Indorsements, 

blank,  84 

conditional,  86 

forms  of,  84-89 

illustrations,  87-89 

liabilities  of  parties,  91 

qualified,  85 

restrictive,  85 
Industrial  savings  banks,  109 
Inflation,  demand  for,  434 
Insurance  of  merchandise,  241 
Interest, 

accrued,  128 

calculations,  1 81-185 

loans,  on, 
call,  178 
time,  180 
rates  of,  204 

tables,  484-492 
Inventory, 

appraisal,  238 

sales,  comparison  with,  253 
Investment  banking,  100,  266-268 
Investment  credit  instruments,  34 


Land  banks,  federal,  114 
Lawful  money,  8,11 
Legal  tender,  8,  11 

issues,  429-431 
Letters  of  credit, 

advantages  in  use  of,  73-74 

commercial,  388 

customers'  liability  under,  135 

domestic  letters,  74 

drafts  drawn  under,  388 


Letters  of  credit — Continued 

import  and  export  letters,  71-73 
purpose  of,  71 
travelers',  75-79 
Liberty     bonds,     basis     for     redis= 

counting,  337-340 
Loans, 
bank, 128 
call,  176-179 
cattle,  194 
collateral,  188-191 
commercial,  175 
cotton,  195-196 
demand,  176 
grain  bills,  197 
merchandise,  193 
mortgage,  199 
rates  of  interest  on,  204 
relation  to, 

capital,  205 

deposit,  150-153,  205 

reserve,  276-281 
time,  179 


M 


Medium  of  exchange,  2 
Merchandise, 

ratio  of  sales  to,  227 

turnover,  223-225 
Merchandise  loans,  193 
Mill  paper,  55 
Minor  coins,  12,  24 
Mint  price  of  gold,  15-16 
Mints,  17 

Monetary  circulation,  tables,  29-30 
Monetary  stock,  12-14 
Money, 

changes  in  form  of,  28-31 

circulation,  12-14 

credit,  forms  of,  28 

definitions  of,  2 

functions  of,  i 

lawful,  8 

orders,  49-50 

paper,  9 

rates,  414-420 

redemption  of,  31 

relation  to  credit,  i 
Money  changers,  94 
Money  market,  factors  affecting,  414 
Morris-plan  banks,  118 
Mortgage  loans,  199 
Multiple  standard  of  value,  448 
Mutual  savings  banks,  108 


INDEX 


505 


N 


National  bank  notes,  10,  26 

inelasticity  of,  168,  301,  323 

origin  of,  167 

profit  on,  169-172 

volume  of,  172 
National  banking  system. 

Act  of  1863,  103 

defects,  301-308 

growth,  104 

origin  of,  102 
National  banks, 

capital  of,  105 

number  of,  104 

organization  of,  123 

reserve  of,  271,  302 

supervision  of,  123 
National      Monetary      Commission, 

recommendations  of,  307 
Negotiability, 

attributes  of,  83 

bills  of  lading,  62-63 

historical  development  of,  8c^82 

meaning,  80 

purpose  ot,  82-83 

warehouse  receipt,  65 
Negotiable  instruments,  82 

law,  83 
Net  worth, 

bank,  126 

ratio  to, 
assets,  227 
debts,  228 
sales,  228 
New  York  bank  statement,  410 
New  York  money  market,  409-426 
Notes  payable,  242-245 
Notes  receivable,  232-234 


Open- market  operations,  202 
federal  reserve  banks,  317 


Panic  of  1907,  307 

Paper  money,  9 

efTect    of    depreciation    upon    ex- 
change, 379 
federal  resers-e  bank  notes,  27 
federal  reserve  notes,  10,  27 
government  issues,  428-431 
national  bank  notes,  26 
United  States  notes,  25 


Pegging  exchange.  380 

PhiUips,  C.  A.,  on  bank  reserve,  286- 

288 
Pittman  Act,  23-24 
Postal  saving  system,  113 
Prices,  (See  also  "Index  numbers") 

influence  of  changes  in,  438-440 

volume  of  currency,  relation  to,  445 
Problems, 

with  solutions,  453-476 

without  solutions,  477-482 
Promissory  notes,  46 

government,  428 
Protest, 

fees,  92 

meaning  of,  91 

requirements  of,  92-93 


Qualified  indorsement,  85 
Quantity  theory  of  money,  440-445 


R 


Receivables, 

purchased  by  discount  banks,  120 

ratio  of, 

merchandise  to,  225-227 
sales  to,  228 
Redemption  fund,  168 
Redemption  ot  moneys,  31 
Rediscounts, 

development  of,  305 

entries  on  the  balance  sheet,  137 

federal  reserve  banks,  313-317,  342 

interbank,  323 
Renewal  of  notes,  245 
Renewal  rate  on  call  loans,  424 
Reserve  banks,  270 
Reserve  cities,  271 
Reserve  in  a  credit  statement,  247 
Reserves, 

bank  statement,  411 

computation,  method  of,  283-285 

federal  reserve  banks,  326,  347 

loans    and    deposits,    relation    to, 
276-281 

national  banks,  302 

reduction  of,  321 
Restrictive  indorsement,  85 


Sales, 

credit  statement,  252 


5o6 


INDEX 


Sales — Continued 

inventory,  comparison  with,  253 

ratio  to, 

fixed  assets,  229 
inerchandise,  227 
net  worth,  228 
receivables,  228 
Savings  banks,  97 

definition  of,  108 

industrial,  109 

mutual,  108 

school,  109 

stock,  109 

territorial  distribution  of,  108 
School  savings  banks,  109 
Second  United  States  Bank,  427 
Securities, 

classes  of,  held  by  banks,  263 

holdings  of  banks,  263-269 

policy    of    investment    by    banks, 
263-268 
Sherman  Act,  22,  433 
Shipper's  draft,  63 
vShipper's  invoice,  62 
Shipping    documents    and    bankers' 

acceptances,  358 
Silver, 

certificates,  10,  25 

demonetized,  431 

dollars,  22 

subsidiary,  24 
Silver  dollars, 

coinage,  22 

legal  tender,  23 

seigniorage  on,  23 
Silver  purchase  acts,  432 
Single-name  paper,  47-48,  185-187 
Stabilized  dollar,  449 
Stale  check,  44 
Standard  of  value,  2 
State  banks,  105-106 

capital,  144 

membership     in     federal     reserve 
system,  327-328 


State  banks — Cordinued 

organization  of,  124 
Stockholders'  liability,  145 
Subsidiary  silver,  24 
Surplus, 

bank,  127 

capital,  comparison  with,  147 

creation  of,  133 

growth  of,  146 

nature  of,  145 


Tabular  standard  of  value,  448 
Tolerance  of  the  mint,  15 
Trade    acceptances,    (See    "Accept- 
ances, trade") 
Travelers'  checks,  51-53 
Travelers'  letters  of  credit,  75-79 
Trust  companies,  106-108 

affiliation  with  a  national  bank,  112 
Trust  receipt,  form  of,  68 
Turnover,  merchandise,  223-225 


U 


Undivided  profits,  127 

compared  with  capital  and  surplus, 

147      ^ 
nature  or,  147 
Unearned  discount,  128 
United  States  notes,  25 


W 


War  obligations,  rediscounting  by 
federal  reserve  banks,  338 

Warehouse  receipts,  64-66 
negotiability,  65 

Warehousing  system  in  Louisiana,  67 

Wilson,  President,  appeal  to  state 
banks  to  join  federal  reserve 
system,  328 


AA    000  600  044    2 


SOUTHERN    BRANCH 

UNIVERSITY  ^^  CALIFORNIA 
LIBRARY 

LOS  ANGELES.  CAUF. 


